Stéphane Monier is head of Investments at Lombard Odier Private Bank.
Upcoming elections in the Netherlands, France, Italy and Germany threaten new gains for populist and anti-euro parties. Yet Europe’s economy continues to go from strength to strength. We believe the continent’s economic resilience could prove a more powerful market force than politics this year. Meanwhile, we see an important role for the Swiss franc in mitigating political risk.
Despite a state of almost perpetual crisis, Europe’s economy continues to grow above its long-term trend. While all eyes were focussed on internal struggles in 2016, including Brexit and December’s Italian referendum, the European Commission estimates all 28 EU economies registered growth (and Italy grew at 0.9%, its highest rate since 2010).
In the final quarter of 2016, economic growth in the eurozone outpaced that of the US, and for the first time in almost a decade, the Commission also projects growth for 2017 and 2018.
Europe’s unemployment rate continued to fall in December, headline inflation rose more than expected in January, and the eurozone Purchasing Managers Index – which measures forward-looking expectations – hit a seven-year high.
Still, robust growth must be set against considerable political risk. This year holds at least four high-risk events: Dutch elections in March, French presidential and parliamentary elections in April-June, likely Italian elections over the summer, and German elections in September.
In all four countries, the risk is that populist, anti- European parties gain power, pursue policies that harm growth, and hold referendums on leaving the euro. Political risks are therefore considerable, endangering not only the possible future of the single currency, but also of the wider European project.
While we acknowledge that these risks are high-impact, in our view they are relatively low in probability. Eurosceptic parties currently garner a worrying 25-30% of the vote in France, Italy and the Netherlands.
But the structure of these countries’ political systems (based on proportional representation, or successive rounds where candidates are eliminated in France) means we believe they will find it hard to come to power.
Even with a strong showing in national ballots, we note that the demands of coalition-making and broader popular objections will likely dilute these parties’ impact. In France, even a presidential victory for Marine Le Pen – to which we attribute a 20% probability – could be tempered by a more moderate parliament, where the majority of policy-making decisions reside.
Our base case is that no Eurosceptic party will accede to power and organise a euro exit referendum in 2017. Italy seems to us the biggest risk, given that a coalition of the Five Star Movement with another anti-euro party is conceivable, the economy is in a poor state, and popular feeling against the euro is strong.
We also note that even if no anti-euro party manages to gain power, popular anger and distrust could continue to build, storing up problems for future years. Meanwhile, the ongoing Greek debt crisis remains a perpetual drag on sentiment towards Europe.
Still, we note that European assets are priced to reflect significant risks. European equities currently trade at around 14 times Bloomberg consensus 2017 earnings estimates, versus 18 times for their US counterparts.
Benign election results this year could, we believe, remove much of Europe’s valuation discount. Given a constructive macroeconomic environment and positive earnings dynamics, we are keeping the overall level of equity risk in portfolios unchanged at slightly overweight, and started to reduce our underweight in European equities in January.
In the fixed income space, the spread between French and German 10-year debt reached a four-year high in mid-February. We maintain our underweight stance in European (and broader developed market) sovereign bonds, given rising inflation and a likely tapering of the European Central bank’s quantitative easing programme from April onwards.
However, we believe the sharp rise of long-term yields in ‘peripheral’ Europe may be overdone. Portuguese 10-year yields reached 4.2% on 7 February, a return that could look attractive when set against the country’s recovering growth, low inflation, current account surplus, and manageable public deficit.
We highlight the Swiss franc (CHF) as an interesting way to hedge European political risk in 2017. We think the Swiss franc is a more natural ‘safe haven’ investment than gold or US Treasury bonds if investors are concerned about Europe and the single currency.
We believe heightened risk around upcoming European elections should prompt investors to buy the franc, and that the Swiss National Bank (SNB) will be forced to accept gradual currency strengthening in 2017.
Of course, the Swiss economy is far from the world’s most dynamic: credit growth and bank lending have slowed after the 2014 imposition of negative interest rates, and exporters labour under a strong currency.
But since my own move to Switzerland in 2009, the franc has appreciated by almost 40% against the euro (including the dramatic removal of the peg in January 2015), while the country’s current account surplus has hovered at around 10% of GDP.
In my view, this demonstrates the resilience and adaptability of Swiss companies and the wider economy. Switzerland’s external surplus, and solid, if unremarkable, growth prospects (the Swiss government expects 1.5% growth for 2016 and 1.8% in 2017) should both support the franc.
Meanwhile, a return of year-on-year consumer price growth in January should ease the SNB’s deflationary concerns. In an European environment fraught with uncertainty, we believe the Swiss franc could have an important role to play.