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2017 - A Year of Political Risk in Europe

Wells Fargo Investment Institute - March 2017

Peter Wilson, Global Fixed Income Strategist in Wells Fargo Investment Institute’s London office, explains why 2017 may be a challenging year for European markets—due in large part to the region’s crowded political schedule.

Transcript: 2017 - A Year of Political Risk in Europe

Title graphic: A Year of European Elections

2017 may well be a challenging year for European markets, due in large part to the region’s crowded political schedule. From our Wells Fargo Investment Institute offices here in London, we’re watching this month’s general election in the Netherlands, where the populist and anti-euro Party of Freedom may win the largest share of the vote. March will also be the month that the U.K. government formally notifies the European Union of its intent to leave the grouping, via an “Article 50” letter, beginning a two-year process of tough and likely increasingly bitter exit negotiations.

The biggest political risk event the markets face is on the other side of the English Channel—the French Presidential election, which takes place over two rounds of voting, on April 23rd and May 7th. Here, there is a strong probability that the far-right candidate, the National Front leader Marine Le Pen, will make it through to the second round, but we believe there is a much smaller, though not negligible, chance of her winning the run-off and becoming the President of France. Since her party’s platform includes the possibility of redenominating French debt from euros into “new francs” and a referendum on EU membership, market participants are treating this outcome as a “low probability/high impact event”—something unlikely to occur, but which, if it did, would have huge market repercussions. 

Title graphic: A Modest but Steady Recovery

And yet, away from politics, the Eurozone economy has been growing at a steady, if unspectacular, annual rate of around 1.6 to 1.8 percent. Business surveys suggest this is set to continue. Deflation fears have faded, and the annual rate of headline inflation is now near the European Central Bank’s target of “close to, but below, two percent.” 

This dichotomy between politics and economics is reflected in the diverging performance of bonds and equities. German 2-year sovereign yields have been making new lows close to negative one percent, indicating bond market participants’ focus on the political risks, and their search for perceived security, even at very high cost. However, the main German equity index, the DAX, is making new highs and already topping many analysts’ year-end forecasts—on the basis that, if worst-case scenarios do not come about, the Eurozone economy may well enter 2018 in better shape than for many a year.

Title graphic: Investor Implications

Our investment advice reflects this complex situation. Outside of Germany, Eurozone bond yields are expected to continue rising, as a result of both the increasing political risk premium, and the natural tendency of interest rates to rise as growth and inflation recover.

Eurozone equities have so far been resilient to political risks, and, although French elections in mid-year may cause volatility, we would expect them to ride this out—and continue to focus on improving macro-economic fundamentals.