Download Heavy Weather in Europe: Key Elections Challenging EU`s Future

March 2017
Heavy Weather in Europe: Key Elections
Challenging EU’s Future
Figure 1: Uncertainty and the VIX
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Implied volatility measures
are not yet pricing the policy
uncertainty ahead of us.
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by Mark Wills, Head of Investment Solutions Group (ISG),
Asia-Pacific and Thomas Poullaouec, Head of Research,
ISG Asia-Pacific
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175
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125
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• Populist candidates in key Dutch, French and German
elections continue pressure on the European Union,
following last year’s Brexit vote
• Election outcomes seen as a referendum on the future
of the European project and measure of populist
sentiment on the continent
• Implied volatility measures suggest political
uncertainty has not been priced in
• Given the uncertainty, investors should consider
volatility protection and tactical flexibility, while
rethinking European bond holdings
In addition to the structural flaws in the Eurozone and ongoing
debt crises in Greece and Italy, elections in the Netherlands,
France and Germany could pose additional shocks to European
integration over the next six months. We take a look at the
disconnect between the low implied volatility measures and
other tail risk measures as we head into the first round of voting
in the Netherlands. We provide a preview of other major
contests over the next six months and how investors might
protect themselves from the potential ballot box shocks.
60
Jan
2007
Apr
2010
— Global Economic Policy Uncertainty (LHS)
Aug
2013
Dec
2016
10
— VIX level (RHS)
Sources: State Street Global Advisors (SSGA), policyuncertainty.com.As of December
31, 2016. The implied volatility measures are forecasts and estimates based on
certain assumptions and analysis.
Markets are Perplexed
Measures of current market sentiment are sending mixed
signals at the moment. From 2007 to 2015, measures of
market and policy risks like the VIX implied volatility index
and the Global Economic Policy Uncertainty index were
well-synchronized in terms of direction (or trends). We note
a disconnect between these two measures since the surprise
Chinese currency devaluation in August 2015. Since that time,
the VIX Index has trended lower, while the Global Economic
Uncertainty Index has risen to multi-year highs (see Figure 1).
Both risk indicators are likely to experience some bumps
in the near future, largely because of the upcoming elections
in Europe. Following the November presidential election in
the US, the policy uncertainty index from the US is much lower
than that of Europe. US voters chose the populist candidate
against all expectations; now the world looks to the populist
candidates in Europe to see if they can pull off similar upset
victories. The low implied volatility measures contrast with
higher readings from the SKEW Index, which suggest that
investors might be more braced for tail risk events like
an unexpected European election outcome over the next
6 months (Figure 2).
Heavy Weather in Europe: Key Elections Challenging EU’s Future
Figure 2: VIX and CBOE Skew Index
SKEW Index
VIX Index
The current political calendar is:
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40
March 31st Article 50 must be invoked by the UK
government to start the Brexit process.
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30
April 23rd France 1st Round presidential elections.
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20
May 7th France 2nd Round presidential elections.
110
10
June 11th France Legislative 1st Round
parliamentary elections.
100
Oct
1996
Jun
2003
 CBOE SPX Volatility IndexVIX Index
Mar
2010
0
Dec
2016
June 18th France Legislative 2nd Round
parliamentary elections.
— CBOE SKEW Index
Source: Bloomberg Finance L.P., as of December 31, 2016. The implied volatility
measures are forecasts and estimates based on certain assumptions and analysis.
Looking at comparative news indices, we find two indicators
that use the same technique as the Global Economic Policy
Uncertainty index (Figure 3). One line focuses on the US,
while the other on Europe. As with the Uncertainty Index,
these two indicators used to move in tandem during the
period from 1997 to 2011.
However, the European index has been higher than that of
the US since the start of the European debt crisis in 2011.
With the uncertainty related to that crisis, the European index
decoupled in 2011 and was slightly more elevated than the US
one. This decoupling has become even more pronounced since
mid-2016, with Brexit, upcoming elections in Europe, and a
revival of the Greek debt saga, all of which seem to outweigh
the continued uncertainty around the Trump presidency.
500
400
300
200
100
Jan
1997
— US-Newsbased EPU
Sep
2003
May
2010
— Europe News Index
Sources: SSGA, policyuncertainty.com. As of January 31, 2017.
State Street Global Advisors
September 24th Germany parliamentary elections.
We believe 2017 has significant potential to disrupt
markets through electorally induced uncertainty and
volatility in Europe. Driven in part by the refugee crisis
emanating from Syria, the focus for national elections is
largely on immigration and security. At the same time,
little is being discussed concerning the European project
and needed reforms, particularly around fiscal union. On
the monetary front, the European Central Bank (ECB) will
continue to provide safety nets, through unconventional
measures and forward guidance, as it has done for some
time now. Its actions are focused on supporting economic
activity across the Eurozone and the continuation of the
monetary union.
Eurozone Continues to Struggle with
Structural Contradictions
Figure 3: US and European News Indices
0
March 15th Netherlands parliamentary elections.
Jan
2017
The battle between pro-Eurozone and anti-Eurozone
candidates this year occurs against continued structural
contradictions within the single currency union. If a
country enters into a fixed-exchange rate regime, it must
stay competitive or it will underperform. As SSGA has
previously argued, the euro has placed serious constraints
on the viability of the Eurozone unless fiscal imbalances
are addressed through regional transfers, similar to what
happens in the United States of America.
In Figures 4 and 5, we see that with regard to both GDP
and unemployment, Germany is outperforming Europe by
a wide margin. Every other major European country has a
performance loss similar to that of Italy. Figure 4 shows the
large divergence in GDP among Eurozone economies adjusted
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Heavy Weather in Europe: Key Elections Challenging EU’s Future
Figure 4: GDP Price Deflators
Why does this matter? Adopting a single monetary policy
for countries with very different fiscal conditions is bound to
end in tears. It means that less competitive countries like Italy
can no longer unilaterally devalue their currency to remain
competitive. Without that flexibility, the Eurozone would have
to consider fiscal transfers to subsidize its less competitive
members. Alternatively, some form of debt mutualization
could also be considered.
Re-Indexed: Q1 1999–100
140
135
130
125
120
115
Region
Jobless
Rate (%)
Youth
Unemployment (%)
Debt to
GDP (%)
GDP Growth
Rate (%)
Europe
9.6
20.9
90.7
1.7
For either of these solutions to be implemented, strong
collaboration among the EU members would be necessary.
The impasse regarding Greek debt relief is a clear example of
the policy problems the EU has with fiscal transfers. This type
of action requires strong leadership at the state level, with a
solid popular backing. So far we have seen little evidence of
that. Meanwhile populist candidates in major Eurozone
countries like the Netherlands, France and Germany are
now challenging the very existence of a common European
community that would continue to allow the free flow of
goods, services and people. Upcoming elections will serve
as a barometer of how open and integrated these European
countries would like to remain.
110
105
100
95
1999
2003
2007
— Price deflator, euro, SA, CA — Germany
2012
2016
— Price deflator, euro, SA, CA — Italy
Source: SSGA Economics Team, December 31, 2016. The GDP deflator shows the
growth in goods and services output adjusted for inflation.
Figure 5: Select Economic Indicators in Europe
Germany
France
Netherlands
3.9
6.5
71.2
1.2
Netherlands
10.0
26.2
96.2
1.1
Geert Wilders’ Party for Freedom (PVV) is a populist party
that has an avowed anti-EU platform. While the PVV is leading
in the polls, it seems unlikely that it can form a government in
its own right. This is especially true because in the past, other
parties have ruled out forming a coalition with the PVV. This is
not likely to result in a strong government. Therefore, despite
the fact that the PVV is ahead at the moment, the current
majority party of centre right, the VVD, will be most likely
prevail to form a coalition government.
5.3
10.2
65.1
2.3
Italy
12.0
40.1
132.7
1.1
Spain
18.6
42.9
99.2
3.0
Portugal
10.5
26.2
129.0
1.9
Source: Eurostat, Trading Economics. As of February 20, 2017.
by the domestic inflation rate since the introduction of the euro.
From this chart, we can see that Germany has been the clear
winner, dramatically outperforming countries like Italy.
Only uncompetitive countries are made to adjust, which creates
a drag on overall Eurozone growth. There are two key points to
be made regarding internal devaluation:
• Adjustment via internal devaluation is painful.
Internal devaluation connotes falling economic growth,
plummeting industrial production, and substantial
increases in unemployment.
• Historical examples of successful internal devaluation
required a highly compliant political culture, a significant
share of services employment, and limited number of
organized vested industrial interests. These criteria do
not describe the current state of the peripheral
European economies.
State Street Global Advisors
The most disruptive outcome for the Dutch elections would
be a win by the PVV, with a sufficiently large share of the vote
(>35%), which would give them the lead in forming a coalition
of “populist” parties. That outcome would pave the way for new
vote: Dutch voters could have a chance to vote to leave the EU
in the months ahead.
Furthermore, if Wilders wins in the Netherlands, it could
strengthen the legitimacy that French populist candidate
Marine Le Pen and her Front National party-would have
with French voters. The PVV results should be watched
closely as a potential proxy for the French elections.
France
Marine Le Pen’s Front National (FN) is leading in the polls,
at least for the first round of voting on April 23rd. Le Pen’s
current polling numbers suggest she will receive more than a
quarter of the first round votes, which would be a postwar high
share for a FN candidate. But if she is unable to win an outright
majority, then a second round vote will occur between the top
two candidates.
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Heavy Weather in Europe: Key Elections Challenging EU’s Future
The opposition parties are in disarray compared with previous
elections. A new centrist party under Emmanuel Macron has
now emerged and is gaining strength against the left-center
party. On the right, François Fillon of Les Républicains has
been badly affected by a scandal involving his wife receiving
parliamentary payments; however, he has refused to withdraw.
The election cycle in France won’t end with the Presidential
elections. Parliamentary elections on June 18th will decide
what the newly nominated government will be able to
implement with the newly- elected assembly. Based on current
information, the future government in France is likely to be
weak and characterized by a “cohabitation” with parliament.
Germany
The Christian Democrats (CDU) of Chancellor Angela
Merkel have fallen behind the SPD in a recent poll. However,
the opposition Social Democrat (SPD) leader Martin Schulz has
become involved in a scandal from his time as EU President.
Should Schulz win in spite of that issue, the implications of
an SPD-led coalition could be very signiifcant for Europe,
as he could break with Merkel on fiscal policy for the EU.
Greece
European finance ministers met in February to try to forge a
settlement of the second review of Greek debt. Creditors want
a higher growth target and will not comment on debt relief. The
International Monetary Fund (IMF) wants more austerity,
pension and income tax reform, as well as debt relief from
creditors. Looking at the data, Greek GDP contracted 0.4% in
Q4, and inflation is now at 1.5%. Greece also has over €6 billion
worth of bonds that must be rolled over in July 2017.
Italy
Former Prime Minister Matteo Renzi resigned as head of the
Democratic Party (DP) and a major split has occurred with the
more left-wing elements of the DP. Renzi wants to clarify his
leadership and bring the national elections forward. The Five
Star Movement (5SM) also has some momentum, despite
scandals surrounding the newly elected, 5SM mayor of Rome.
We believe that new Italian elections are likely before year end
and that Italy continues to be one of the weaker links of the EU,
as we discussed earlier.1
Brexit
Meanwhile, deliberations over the UK’s planned departure
from the European Union grind on. The 137-word Brexit
legislation has been ratified by the House of Commons while
individuals within the House of Lords continue to express
their dismay over Brexit. European Commission President
Jean-Claude Juncker has said negotiations between London
and Brussels will be tough, long and expensive. Estimates
suggest it could take as long as two years and cost as much
as 60 billion euros.
State Street Global Advisors
What does this mean for investors?
If populists prevail across all three polling contests, we could
easily begin to see the abandonment of the euro if not the
dissolution of the entire European Union. In our mind there
are three possible outcomes for the elections:
1. Populist parties taking power in the Netherlands,
France, and Italy with the implosion of the EU not
far behind.
2. Mainstream parties prevail and thus preserve the
EU status quo, nonetheless with renewed crisis risk
over debt and structural contradictions everpresent.
This would be the case with weak governments in the
Netherlands, France, and Germany, with no ability to
agree on fiscal reforms.
3. EU strengthening: a generation of new leadership in
France and Germany with a pro-EU agenda and a strong
popular backing, coupled with a sucessful Brexit for the
EU, could lead to greater fiscal stimulus by the EU.
So far, markets seem to be positioning for the uncertainty by
shorting French government bonds relative to German bunds
and underweighting European stocks (mostly in the banking
sector). There has not been much interest in shorting the euro
or credit.
In the case that mainstream parties are able to keep the
populists in check, we see the potential for European stocks
to rally and Bund yields to increase.
In the case of neutral to negative outcomes, one could see
a large increase in market volatility accompanied by
1. A much stronger US dollar relative to the euro
2. Massive expansion in European bond spreads, especially
in the high debtor countries
3. Potential capital flight to the US
For investors, we suggest three actions to consider:
• Be tactical: overweight equities (mainly in the US and Japan),
given current economic and earnings tailwinds. Currency
markets, like the Euro and defensive currencies (CHF and
JPY), are likely to be impacted given that Euro’s positioning
and implied volatility remain contained relative to the
uncertainty ahead.
• Manage volatility carefully: consider volatility based
signals or option strategies to adjust your equity allocation.
• Rethink bond holdings, especially the role of sovereign
bonds for Euro-based investors given the potential for
greater differentiation in spreads relative to bunds.
1
“Et Tu Brute: Is the Italian Referendum the Second Act of the European Union’s
Tragedy?” by Mark Wills, SSGA IQ Insights, October 2016.
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Heavy Weather in Europe: Key Elections Challenging EU’s Future
Glossary
CBOE SKEW Index, or SKEW Index A tail-risk focused market index derived
from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk
is calculated from the prices of out-of-the-money options on the S&P 500. SKEW
typically ranges from 100 to 150. A SKEW value of 100 means that the perceived
distribution of S&P 500 log-returns is normal, and the probability of outlier returns
is therefore negligible.
Global Economic Uncertainty Index Index constructed from three underlying
components: newspaper coverage of policy-related economic uncertainty
(search results from 10 large newspapers (Miami Herald, the Chicago Tribune,
the Washington Post, the Los Angeles Times, the Boston Globe, the San Francisco
Chronicle, the Dallas Morning News, the New York Times, and the Wall Street
Journal)), number of federal tax code provisions set to expire in future years (10),
and disagreement among economic forecasters as a proxy for uncertainty.
VIX®, VIX Index or CBOE Volatility Index The VIX, often referred to as the equity
market’s “fear gauge,” is a measure of market risk based on expectations of 30-day
volatility. It is constructed using the implied volatilities of a wide range of S&P
500 index options—both calls and puts. The VIX volatility measure is meant to
be forward looking.
ssga.com
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Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or
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The information provided does not constitute investment advice and it should not be
relied on as such. It should not be considered a solicitation to buy or an offer to sell a
security. It does not take into account any investor’s particular investment objectives,
strategies, tax status or investment horizon. You should consult your tax and financial
advisor. All material has been obtained from sources believed to be reliable. There is
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The views expressed in this material are the views of Mark Wills and Thomas
Poullaouec through the period ended February 20, 2017 and are subject to change
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