European politics is in flux, but the news is not all bad for investors
- Tai Hui says the EU has a headache on its hands this year with Brexit, fiscal discipline and mass protests, on top of volatile parliamentary elections in May. Even so, there are quality companies that are less sensitive to market volatility
Asian investors have shied away from Europe in recent years, because of the perception of political problems in the region, dating back to the Greek debt tragedy in the early 2010s. The Brexit referendum in 2016 has led to a massive political headache for the British government. More recently, the “yellow jacket” protests in France and the stand-off between Italy and the European Union over its budget deficit have also captured the headlines.
Historically, the relationship between European politics and market performance is far from clear. The best example is the UK’s FTSE All-Share Index, which hit a record high in the first half of 2018, almost two years after the Brexit vote. This is despite the fact that investors believe the uncertainties created by Brexit will damage the UK economy, especially in business investment and job creation.
There are two reasons behind this seemingly illogical outcome. First, a large number of British companies generate their profit internationally, with modest direct exposure to the UK economy. Hence, robust global demand is more important for their earnings than Brexit’s outcome.
Second, Brexit has weakened the British pound. This would imply every dollar of overseas profit would be translated into more British pounds when repatriated, and would improve earnings performance.
Notwithstanding the mixed connection between politics and market performance, political developments could continue to challenge the unity and integrity of the European Union and the euro. Populism is on the rise even as unemployment falls and wages gradually increase. Public discontent reflects the growing inequality in these countries, where lower-income groups believe immigration and globalisation have hurt their livelihoods.
One piece of good news is that, following the 2008 global financial crisis and the 2012 European debt crisis, government deficits have improved, including in peripheral European countries such as Ireland, Spain and Portugal. That should allow for a modest fiscal boost. However, populist demands mean governments are under pressure to spend more, a factor that could undercut the EU’s call for fiscal discipline.
Following the “yellow vest” protests, French President Emmanuel Macron has agreed to a number of reforms to calm protesters. These concessions, which include wage rises for low-income workers and tax cuts for pensions, would cost up to €8-10 billion (US$9-11 billion), according to government officials.
In Italy, the government finally backed down on its budget proposal following the EU rejection, cutting its projected deficit from 2.4 per cent of gross domestic product to 2.04 per cent. Yet, the Italian government only conceded after the market sent its government bond yields higher, raising the cost of borrowing.
Fragmentation in a number of national parliaments across Europe, where there is a lack of a ruling party or a stable coalition, implies that generous tax cuts or government spending plans would be a useful tool for an incumbent government to appeal to voters.
Compared with fiscal policy, the room for monetary stimulus is even more limited. Unlike the US Federal Reserve, which has already raised interest rates by 2.25 percentage points since 2015, the European Central Bank’s policy rate is still negative. It is not possible to cut interest rates to stimulate the economy without damaging savers and depositors further.
While there is always the option to restart quantitative easing, the political support for this measure is by no means unanimous. Many richer nations in the region see the central bank buying government bonds as an encouragement to some governments to drag their feet on fiscal consolidation and tolerate irresponsible spending.
There is little doubt that European politics will remain complicated in the foreseeable future. One risk is that more eurosceptic politicians are voted into the European Parliament in elections in May, although, reassuringly, a large share of voters still support the euro. The integrity of the European monetary union could be tested again in the next downturn, as much-needed fiscal integration and banking regulatory reform to reinforce the monetary union have been far from satisfactory in the past eight years.
This is likely to affect the bond market first, since this is more closely linked with government debts and deficits. However, the subsequent spillover to the equity market should not be overlooked.
Having said that, there are quality companies, such as those with a diversified source of earnings or a strong balance sheet, that could be less sensitive to this volatility.
Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management