European Elections: Just Another Wall of Worry To Climb
After Brexit, the U.S. election, and the Italian constitutional referendum in 2016, more political events await in 2017. In the U.S., investors will follow the showdown between Trump and his Democratic (and Republican) opponents in Congress as the new president attempts to get his spending programme approved. In Europe, several national elections are preoccupying investors, as fringe, anti-European political parties are polling well. While unexpected political results can shock markets for a short period (as seen post-Brexit and for a few hours after Trump’s victory), don’t expected any of the known events on the political calendar to push U.S. or European equity indexes into the next bear market. On the contrary, investors buy into risk, which results in equity gains. On an investment landscape denuded of risk, investors don’t get paid, as little or no risk is undertaken. In fact, we expect equity indexes to be most vulnerable to a correction as the blue sky outlook is reaffirmed in 2017. Strong macroeconomic data, the appearance of strong company earnings, and the removal of political risk should concomitantly (and paradoxically) mark a high point in equity indexes.
This week we give our two cents on the political risks upcoming in 2017.
Trump and a potential Congressional roadblock. Trump and his White House team will be working on multiple deals, from defense spending to health care. And they will be sitting across the table from not one party but 535 independent actors—100 members of the Senate and 435 members of the House of Representatives. Even though Republicans hold majorities in both chambers, Trump’s path to getting what he wants is strewn with hazards. Senate rules allow the minority party—in this case, the Democrats—to thwart lots of deals with just 40 votes, so Trump will need to reach out to the likes of Chuck Schumer, the Senate minority leader and fellow New Yorker, who is under enormous pressure from progressives to resist every Trump entreaty. Much of the president’s agenda won’t please Republicans either; they aren’t even fond of his massive budget cuts. But the biggest obstacle Trump faces is math: His cuts need to pay for his massive tax reductions and defense spending—and that won’t be easy.
Dutch Election. While there was much concern this past week that Geert Wilders, the anti-European populist, would win the election in the Netherlands, in the end the incumbent socialist Mark Rutte hung on to win. The Dutch election result was overshadowed by the Fed’s FOMC meeting, but in any case was a non- event.
French Election. The French presidential election 2017 is shaping up to be one of the most unpredictable in history. While there is much angst among international observers that anti-European candidate Marine Le Pen will win, in reality her chances are very small. Much less than Trump’s chances of winning the U.S. election, we would say. In the French election system, a candidate must obtain 50% of the votes to win the presidency. With a multi-party system, it is unlikely any candidate will ever garner 50% of the vote in the first round. Even if Le Pen makes it to the second round of the election, her party, the Front National, has no political allies, and electors from all other political groups will cast protest votes against Le Pen and in favour of her second round opponent. This likely winner as of today will be Emmanuel Macron. His policies will be more or less status quo. In the end, the French election will be another non-event.
German Election. Angela Merkel facing criticism over her controversial open migration policy, could she lose the federal election later this year? Former European Parliament President Martin Schulz is standing for the SDP in a bid to become Germany’s next Chancellor. Despite the criticism of Merkel and her sinking support, a majority of voters support the idea of her remaining Chancellor. Her popularity is much weaker than it was months and years ago but it is still at a level of more than 40%. In the end, we expect some new coalition to be formed following the election, whoever is elected as Chancellor. The political risk of the German election is small, and likely a third non-event in Europe.
We expect more political headline risk coming out of the U.S. this year as Trump’s plans get hung up in Congress. As Trump’s programme gets watered down, equity markets could use any “disappointments” to take some profits on overvalued equity positions. In Europe, the elections may be restraining new money from coming into equities. Some strategists at BNP Paribas and Société Générale are expecting renewed, heavy inflows into equities after the European election risk has past. We, on the other hand, believe that waiting to invest once there is no risk on the horizon is not when you want to buy. In our DGR Strategy, we are overweight European equities, which are still playing catch-up to U.S. equities. We will be looking to cash out of European equity positions once the election risks are past.
The real political risk this year is not from the Brexit fallout, the feasibility of Trump enacting his programme or the European elections, but rather from unforeseen risks. Geopolitical risks are always lurking and with U.S. equity markets teetering on a cliff, any spark could ignite a sell-off. While “conventional terrorism” is priced into markets, we don’t think a military showdown with North Korea is being priced into equity risk. This past week U.S. Secretary of State Rex Tillerson said the military option with North Korea is on the table, ending Obama’s wimpy “strategic patience” approach with North Korea. It is interesting that Wall Street institutions are even mentioning this risk today. This is just one example of a geopolitical risk that we may face this year. As these risks tend to be “black swans”, we can not predict today what events may occur and if they will serve to increase fear in the markets.
In sum, markets will continue to rise on known, well-defined risks, such as the European elections or previously discussed news surrounding Trump. Unexpected and un-priced risks will be the most likely trigger of a stock market sell-off in 2017. We continue to believe holding equities until something unexpected occurs that pricks the bubble is not an investment strategy, but rather gambling. Upside potential relative to downside risk in U.S. equities is at the most unfavourable level since at least the tech bubble. We remain extremely cautious and have exited all U.S. equity positions in our DGR strategy this past week. Better value and greater upside potential can be found in Europe and emerging countries.
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