Viktor Nossek, Head of Research at WisdomTree Europe, explains why emerging political risks do not primarily apply to equities, but do apply to the euro and peripheral bonds.
Given the solid trend in the near-term economic outlook in the U.S., the stabilization in emerging markets in this regard, and the moderate performance in Europe, European equity markets should prove resilient to the political uncertainty factors emerging in Europe. These could change the European economic and financial architecture for decades to come.
So far, bank efforts toward rapid restructuring and recapitalization ahead of potential political fallout are leading to a strengthening of European equities in 2017. This eases concerns about systemic risk in some of the largest banks. For investors, there are opportunities in the European equity market due to the significant discount at which bank stocks are currently generally valued.
From WisdomTree's perspective, investment strategies with a broad positioning in European equities and a focus on large- and mid-cap stocks are likely to perform strongly amid positive sentiment in the financial sector. In addition, investors can counter risks associated with pessimistic assumptions about the development of the euro by adopting strategies with additional currency hedging and/or a focus on exporting companies.
WisdomTree's outlook for investing in European fixed income is tinged with pessimism. Given Donald Trump's victory in the U.S. presidential election, positive sentiment among high- and low-grade sovereign issuers has evaporated. In addition, there are other macroeconomic events contributing to the pessimistic outlook for fixed-income investments, such as the "Brexit", The expiration of the ECB's bond buying program and the "no in the referendum on constitutional reform held in Italy in December 2016. All of the above events have involuntarily led to an increase in the price of borrowing. As a result, any domestic demand-led growth momentum that may emerge in 2017 could be undermined. Similarly, a significant improvement in employment and wage levels in France and Italy, the weakest core EU countries, could be delayed.
The biggest macroeconomic risks in Europe for 2017 stem from the lack of spending policies and a non-existent agenda to boost investment, as Donald Trump is pursuing in the United States. Euroskeptic movements see 2017 as an opportune year for a more far-reaching realignment of the political agenda in Europe, if the newly elected governments after the political elections in the Netherlands (in March), France (in May), Germany (in September), as well as Italy (date not yet known at this time), decisively oppose the strict fiscal constraints and bank bailout programs imposed by the EU. The weakest link in the EU chain is Italy. Here, the current government of technocrats looks vulnerable in the face of growing support for euroskeptic parties on the left ("Five Star") and right (Lega Nord) camps.
Against the backdrop of these events of macroeconomic relevance, the chart shows how the weakest European sovereign bonds have come under increasing selling pressure, with spreads on German bunds widening despite the ECB's intervention in bond markets rising to around 7.5% of euro area GDP on an annualized basis.
Monetary policy support at the absolute minimum
The ECB's decision to simultaneously extend and reduce its bond-buying program reflects monetary policy support for the euro area that is at the bare minimum. Its path toward recovery is still far from self-sustaining momentum. In particular, the timing of the end of bond purchases seems inappropriate, if not risky, also given the upcoming elections in Europe this year and the Fed's aggressive monetary policy stance in the U.S.
At WisdomTree, while the ECB's extension of its quantitative easing program is expected to act as a "shock absorber" to some extent, it is not expected to have an impact on inflation should serve. Investors, on the other hand, must prepare for a period of renewed political uncertainty: ahead of the upcoming elections in the Netherlands, France, Germany and Italy, Eurosceptic parties are gaining support in the polls. The reduction of the monthly bond purchase volume of EUR 80 billion. to EUR 60 billion. from March to at least December 2017, however, will lead to the "run-out" of of the program coincides exactly with the launch of tighter monetary policy in the U.S.
The attempt to prevent a rise in bond yields in Europe in parallel with the increasing momentum in U.S. government bond yields may have proved difficult in view of the EUR 20 billion reduction in the purchase of high-quality bonds. per month ultimately prove difficult. Yield-hungry European investors will look to the significant yield premium on U.S. government bonds and the upside potential of the U.S. dollar. This calls into question the value of investing in German Bunds or Italian government bonds. There is a risk that, in the wake of a widening interest rate differential between the U.S. and Europe, the ECB may be forced to expand the quantitative easing program again to counter the selling pressure weighing on European government bonds. By risking its credibility as a party effectively intervening in bond markets, the ECB once again prepared the ground for speculative investors, who could bet on developments in the euro area's weakest sovereigns this year, as well as the euro itself.