Credit Suisse launches European Risk Barometer ahead of key elections Donnerstag, 09. März 2017 - 09:00

Europe is about to embark on a defining political period as upcoming elections in founding nations may reshape the EU political landscape and trigger a higher risk premium in markets. Credit Suisse has developed a Risk Barometer, which will be regularly updated, to gauge what level of ‘EU/euro’ risk is priced in across markets. The Barometer, along with an outline of three possible political scenarios, will help investors navigate through this period starting with the Dutch election and finishing with the German federal election. It provides a quick way to assess the level of concern about systemic risk discounted by European capital markets.
 

Credit Suisse strategists have outlined three scenarios for Europe’s political outlook as it begins an important period that will incorporate key elections, Brexit and Greek funding solutions. The past six months have provided positive economic surprises and improved earnings for European financial markets, but the outlook may prove trickier to navigate. “The recent positive tailwinds driving profits may diminish and political risk will come more into the foreground as we approach elections in the founding member nations of Europe,” said Pierre Bose, Head of European Strategy at Credit Suisse. 

The scenarios that could emerge from this politically driven period can be summarized in a positive, a central and a negative scenario:

• The positive scenario sees Greece receive the next round of funding, a benign outcome in the Dutch elections and that centrist, pro-reform, pro-European candidates win both the French and German elections.
• The central scenario sees the bailout review in Greece drag on close to debt redemptions due in July, government formation in the Netherlands take time due to party differences, Emmanuel Macron win the presidential race in France but with the unenviable task of trying to form a stable government with a clear mandate across party lines. Divergence at the ECB grows as the end of Mario Draghi’s term draws closer and a lack of forward momentum remains in Italy prior to 2018 elections.
• The negative scenario sees Greece struggle for funding, Italy continue to struggle with non-performing assets and a Marine Le Pen presidency in France create disharmony at the core of the EU and policy paralysis domestically. 

Risk Barometer to help investors to navigate markets

The Barometer was designed by Credit Suisse strategists to gauge the level of risk priced into capital markets based on a spectrum of risk garnered from 10 years of data which includes the Lehman default, the Greek crisis, Brexit and the Italian Referendum. At this initial stage, the Barometer indicates a market-wide absence of concerns about systemic risk. Looking across sectors from money markets and fixed income to equities and currencies, Credit Suisse strategists find that relative to recent history the market is currently scoring approximately 2 on a scale of 0 to 10 – where 10 means valuations reflect deep investor concerns about future risk.
Whilst not suggesting risk complacency, this nevertheless suggests asset prices have yet to signal an elevated level of concern about systemic risk moving forward. This is most visible in liquid short-term funding markets, low government and corporate bond yields, strong equity performance and low implied volatility in both equity and credit markets. Conversely the strongest risk signal in Europe is the undervaluation of the Euro.

First in line: the Dutch election

The Netherlands will be the first country to kick off the busy political calendar this year, with a general election scheduled for 15 March. Opinion polls had the far-right Freedom Party (PVV) candidate Geert Wilders leading the race with around 18% of voter intentions since the beginning of the year. In recent days, VVD’s Conservatives have returned to the race, tracking vote intentions just ahead of the PVV making it a close call. Despite support for the PVV appearing to have doubled since the 2012 election, Credit Suisse strategists give a low probability of the PVV entering government in the Netherlands.
The country has traditionally been governed by coalition governments, with the parliament’s 150 seats allocated according to absolute proportional representation. Current Liberal Prime Minister Mark Rutte and other mainstream parties have ruled out entering a coalition with the anti-establishment party. That said, Credit Suisse’s strategy team believes the new governing coalition may be more unstable given the prospect that without Mr. Wilders in government, the coalition would be composed of a relatively large number of small parties. A further risk is that a decent showing by Mr. Wilders is seen as a boost to the electoral prospects of radical parties elsewhere in Europe. Markets are likely to take the Dutch elections as a signal for the upcoming important French elections. 

French election poses the most significant risk for Europe

Credit Suisse strategists take the view that the French presidential election, scheduled for 23 April (1st round) and 7 May (2nd round), poses the most important risk for Europe this year. With less than two months to go until the first round, National Front (FN) candidate Marine Le Pen is leading most opinion polls with around 26% of support in the 1st ballot. The populist candidate has put the renegotiation of EU treaties and returning to a national currency at the heart of her program. Credit Suisse strategists do not see Marine Le Pen being elected as their central scenario, as the hurdle to win the second round remains quite high for her. However, the strategy team thinks any narrowing of the polls in her favor will create a high degree of volatility in the markets, as a populist accessing the French presidency would have far reaching consequences for Europe. 

Political risk not limited to elections

During the course of the first quarter the UK government is expected to trigger Article 50. Discussions with regional assemblies including the Scottish National Party and separately discord within both the Conservative and Labour party indicate even reaching the starting line prior to discussions with the EU will be challenging. Separately Greece has over EUR 6bn in bond redemptions due in July with the incumbent government strongly resisting further austerity measures, Germany resisting debt haircuts and the IMF resisting approving further funding before a longer-term solution to restructuring the national balance sheet is found. Italy and Spain, albeit perhaps improbable, could also face early elections further adding to changes faced by Europe. 

A break up of the Eurozone is not likely

The exit of a euro member country, “weak” or “strong”, remains quite unlikely now as does a break-up of the overall system. That said, while economic fundamentals have improved substantially, debt sustainability is still in question in Greece, Portugal, and Italy, in particular. In this light the ECB’s asset purchases have suppressed euro break-up risks albeit, arguably, also reducing pressure for reforms. A loss of confidence in Italian debt could trigger a crisis but a new government empowered to enact reforms would significantly improve investor confidence. Importantly, institutional safeguards against a euro break-up remain incomplete. Making the euro-system “complete” would require a more stringent definition of how countries share risks and who bears risks. Without such stringency, moral hazard will not be limited and commitments to even a limited fiscal union will not be forthcoming. 

Credit Suisse takes a constructive but conservative stance on risk assets

In an environment of low bond yields and already strong equity returns, managing overall portfolio risk and diversification are key. Credit Suisse strategists say that fixed income high quality corporate bonds are preferred, the safe haven quality of German Bunds over their European peers and argue in favor of protecting against periphery risk via an underperform view on Spanish government bonds. In equities, the effect of an adverse election outcome in France will be most keenly felt in the periphery so an underperform view on the Italian market is maintained as it has demonstrated an elevated sensitivity to region-wide political uncertainty and the performance of the financial sector. After a strong performance in the last six months, the strategists have taken a defensive tilt in equities via a preference for defensive over cyclical sectors. With respect to currencies, Euro weakness should be balanced by strength in the US Dollar, Yen and Sterling. “Low implied volatility in equities and currencies afford the chance to protect portfolios or assume exposures in a more conservative manner,” explains Pierre Bose. He adds that it bears emphasizing that caution is tempered on political risk in Europe with positive signals from economics and earnings both in the region and globally.