Politics in Europe: Taking the temperature 2019

Michael Browne, Portfolio Manager European long/short takes a closer look at the region’s politics for the year ahead.

11 March 2019

Politics in Europe: Taking the temperature

Despite a relatively uncrowded political timetable in Europe, the threats and tensions which have erupted over the past five years are likely to prove disruptive and economically significant this year. With the future of Europe's politics – and thus its economy – hard to predict, we have set out where the potential risks are to the region's stability.

Germany

Risk to European stability: 5
Germany risk to European stabilityWith a successor chosen to Angela Merkel, her career as a politician is almost over. She has resigned as leader of her party, but will try and see out her time as Chancellor. A new administration will emerge, probably sooner than expected, as in four of the five cases where this has happened, the Chancellor has not seen out the full term. Her successor, Annagret Kamp-Karrenbauer is widely seen as Merkel 2.0. In the meantime, expansive fiscal policies to help a rapidly slowing economy are not currently forthcoming. A weak first half of the year, coupled with gains for the right-wing Alternative für Deutschland (AFD) in May’s European elections could be the trigger for a very difficult second half of the year.

France

Risk to European stability: 2
France risk to European stabilityPresident Emmanuel Macron’s seemingly complete hold on power has been undone by the ‘Gilet Jaunes’, a collective street movement which brought France to a standstill over the six weekends before Christmas. Their demands, at first, were against a large tax rise on diesel to pay for the country’s transition to renewable energy sources, and have spread to nationalist, protectionist policies championed by the right-wing National Rally (formerly the National Front). The weakness of Macron’s En Marche movement has always been its lack of organisational structure. If the French economy is as weak as we expect in 2019, his leadership will be further pressured but not punctured. A post-Brexit dispute with the UK could prove to be an advantage.

Italy

Risk to European stability: 8
Italy risk to European stabilityThe instability of the current ruling administration has been underlined by success in recent polls for the Lega party (right wing), putting it ahead of its coalition partners 5 Star (left wing). The coalition is widely seen to have failed over budget negotiations with Europe and a tougher stance with Europe is the key attraction of the historically anti-EU Lega. Elections are very likely this year but the economy, clearly in recession at the moment, may well have turned the corner as the modest fiscal package of tax cuts takes hold. A European-wide recession could cause Italian banks to stumble once again, the budget deficit to soar and the debt-to-GDP ratio start to climb above 130%. That cannot continue for too long without the European Union (EU) feeling compelled to step in – something that would play very badly with voters, both in Italy and around Europe. The situation is highly unstable and has the capacity to enter a critical phase.

Spain

Risk to European stability: 2
Spain risk to European stabilityWith elections due after Easter, Spain is set for another period of uncertainty. While the PP (centre right) will lose seats to the PSOE (centre left), overall, the left is unlikely to command a majority and will have to rule with support of one of the regional parties. Podemos, the left-wing scourge of the establishment has lost ground but will still be a presence. On the other hand, it is quite possible that the centre right, with the support of the new right-wing populist party Vox could command a slim majority. Almost any result could happen. The recent enormous rise in the minimum wage could be a sign that corporations are set to lose under any new government. The economy is slowing but not at the same rate as Italy, and Spain and Portugal may well turn out to be a much lower risk than in the previous decade.

UK

Risk to European stability: 10
UK risk to European stabilityBrexit is seemingly engulfing all its participants in an operatic dance of death. What can be said about the UK with any certainty? Will there be a ‘no deal’ Brexit or a deal of some sorts? Will the Labour or Conservative parties survive and is a new centrist party emerging? Is there going to be a second referendum or another general election? Could we have an Irish crisis? The second largest economy in Europe might be cutting itself off from 50 years of economic history, with significant dislocation to itself and others. Will the Bank of England be forced to raise rates because of the inflationary implications of a weak sterling or cut them due to a Brexit/European recession taking hold? The economy has performed far better than anyone thought since 2016 but the risk is high – and uncertainty is higher.

Greece

Risk to European stability: 5
Greece risk to European stabilityThe Greeks seem to be heading for a mid-summer election and all the polls suggest New Democracy, a liberal-conservative party will take over from Prime Minister Alexis Tsipras and his Syriza party. This will inevitably mean a more nationalistic government, but also one more in-tune with the EU fiscal demands. Thus the risk from Greece is lower than it has been for a long time.

Poland, Hungary and Portugal

Risk to European stability: 1
Poland, Hungary and Portugal risk to European stabilityParagons of stability for very different reasons, these countries could well emerge as the templates for others to copy in recovery. But will it be the populism and nationalism from Central Europe or the mild socialism of Portugal? Individually they present no risk but if larger economies were to copy them, they could be.

Ireland

Risk to European stability: 5
Ireland risk to European stabilityFor Ireland there are three key issues: the Irish government’s stance on the Northern Ireland border, the weakness of its current government and the EU drive to stamp out its low corporate taxes. We could see the current government lose it all by using its veto over the border, sparking a considerable recession and backlash from the EU, which might ban beneficial corporate tax rates. In turn, this could usher in a more unstable and economically weak Ireland, which still has one of the highest debt-to-GDP ratios in the EU. It’s a small country at the centre of the Brexit risks and opportunities.

European Union

Risk to European stability: 7
European Union risk to European stabilityIt seems odd to place the bureaucrats from Brussels in the spotlight, but in a period of political vacuum, it is a logical step. In addition, Mario Draghi, Jean-Claude Juncker and Donald Tusk, presidents of the European Central Bank, the European Commission, and the EU Council of Ministers are all due to be replaced this year and there is significant room for political error. Throw in a Parliament with many MEPs with a EU-sceptical view, elected by protest-fuelled voters and you have a real risk of instability during a period of economic weakness. Should an Italian bail-out need to be cobbled together, there may be a lack of willingness, cooperation and leadership in those institutions that need to find answers.

The Investment view

In 2018, we took a cautious investment stance towards European markets, after they peaked in January. Any signs of positive momentum were quickly dashed by the Italian recession, the French political crisis, the Chinese slowdown and the ongoing Brexit negotiations. Our proprietary macro matrix has been very bearish since autumn 2018 and remains the best indicator of continuing economic malaise.

Political tension should not come as a surprise, with Europe having failed to recover fully since 2008. While Europe was able to cope with the collapse of Ireland and Greece by imposing severe austerity measures, this course of action will not work elsewhere. The scale and persistence of political change is now ushering in a new era: change is often good but is also unpredictable and the radical nature of a populist, nationalist, socialist and protectionist ruling political class which is emerging is deeply unsettling for investors and corporates alike.

As long/short investors, we will continue to be cautious and risk averse on European equities, until this period of economic slowdown and perhaps recession, coupled with political upheaval, is over.


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