MARKET INSIGHTS Market Bulletin 23 February 2017 The European political project at a crossroads? IN BRIEF Twenty-five years after the signing of the Maastricht treaty, the European political landscape is more fragmented and polarised than ever, in a year when key member states such as Germany, France, Italy and the Netherlands are all facing general elections. Though most analysts believe that populist outcomes are unlikely, uncertainty has increased in several countries and political risk premia have started to build in a number of sovereign bond markets. Caution is understandable, given Europe s track record of under-performing other developed markets. But investors should also recognise that a more reflationary global environment will benefit European companies more than most. Absent a major political disruption, we would expect these positive fundamentals to assert themselves in European equity markets over the course of 2017. EUROPEAN POLITICAL LANDSCAPE: GREATER FRAGMENTATION AND POLARISATION LEADS TO HIGHER UNCERTAINTY A recent study by Ipsos Global Advisor showed that most Europeans believe their countries are in decline, have little confidence in their governments and want new strong political leaders to bring fundamental change 1. This sense of unease and dissatisfaction with the status quo has sapped support from established, more centrist parties in favour of left and right wing populists, and left the political landscape increasingly fragmented (Exhibits 1 and 2). AUTHORS Vincent Juvyns Global Market Strategist Maria Paola Toschi Global Market Strategist Tilmann Galler Global Market Strategist The European political landscape is more fragmented than ever EXHIBIT 1: EVOLUTION OF AVERAGE SCORE OF WINNING PARTY AND NUMBER OF PARTIES PER ELECTION WITH AT LEAST 1 OF VOTES (5 YEAR AVERAGE) 43 Average score of winning party (LHS) 10 41 Number of parties per election with at least 1 of votes (RHS) 9.5 9 39 8.5 37 8 35 33 31 29 27 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012 Source: ParlGov, The Economist, J.P.Morgan Asset Management; data as of 15 February 2017. 1 Ipsos Global Advisor, study published on the February 6th 2017, focussing mainly on five European countries (France, Spain, Italy, Germany and the United Kingdom). Interviews conducted December 2016 to January 2017. 7.5 7 6.5 6 5.5 5
Support for populist parties is increasing across Europe EXHIBIT 2: VOTE INTENTIONS FOR MAIN EUROPEAN POPULIST PARTIES 30 25 20 15 10 5 0 2011 2016 Alternative für Deutschland Syriza Podemos Movimento 5 Stelle Front national Source: National surveys, J.P. Morgan Asset Management; data as of 31 December 2016. These developments have significantly increased uncertainty about the outcome of the various elections that will take place this year. Though most analysts believe that a populist outcome is unlikely, investors can t help remembering that the same was said about Britain voting to leave the EU and the election of Donald Trump. The packed political calendar is of course important for investors, and we have now seen the emergence of political risk premia in financial markets, as seen most clearly in the recent spread widening between French and German 10-year sovereign bonds yields (Exhibit 3). In this paper, we look at what is at stake, the forces involved and the potential outcomes of the upcoming elections in Germany, France, Italy and the Netherlands. Italian and French spreads over Germany have recently increased EXHIBIT 3: SPREADS OVER GERMANY 2.5 2.0 1.5 1.0 0.5 Italy France Netherlands 0.0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb 2017 2017 Source: Thomson Reuters Datastream, J.P. Morgan Asset Management; data as of 21 February 2017. GERMANY: BUSINESS AS USUAL OR UPSET FROM THE LEFT? What s happening? On 14 May 2017, the state election in North Rhine-Westphalia, the most populous state in Germany, will help set the scene for the Federal election on 24 September 2017, when Angela Merkel, Christian Democratic Union (CDU) will be seeking re-election in her twelfth year of office. Victory would make her the second-longest serving chancellor in post-war Germany. Her main rival is Martin Schulz, Social Democratic Party (SPD), former president of the European Parliament, who secured the candidacy in a surprising upset vs. party head Sigmar Gabriel. Who is running and what are their political positions? Looking at the raw data, Germany s economy is currently in a comfortable position. At 3.9 the unemployment rate ILO is at a record low, while net exports are at a record high, consumer sentiment is benign, and the fiscal budget is in balance. In this environment, the political debate is more about wealth (re-) distribution and preservation and less about economic reforms. Merkel and the Christian Democrats are likely to raise the idea of tax relief on middle income households while Schulz and the Social Democrats favour an increase in spending for education and infrastructure, financed partially by higher taxation of the wealthy and capital income. The rise of the Eurosceptic, anti-immigration Alternative für Deutschland (AfD) has lost momentum, because of political infighting and the success of the ruling coalition in reducing the influx of refugees. However, both the migrant crisis and the future of the EU and the eurozone will both loom large in the election campaign, including the implications of Brexit and the appropriate level of financial integration in the eurozone. The nomination of Martin Schulz led to a dramatic change in the recent polls (Exhibit 4), transforming what looked likely to be a boring re-election bid into a neck-and-neck race for the chancellorship. The Social Democrats jumped 10 in recent polls, with all other parties losing ground. If the polls are right, the following coalition governments are possible: Grand coalition (CDU/SPD), with 65 of popular vote; Chancellor Angela Merkel Red-Red-Green (SPD/Linke/Green), with 46 of popular vote; Chancellor Martin Schulz Jamaica coalition (CDU/Free Democratic Party (FDP)/Green), with 46 of popular vote; Chancellor Angela Merkel No other combination is currently likely, since all parties rule out a coalition with the AfD. 2 THE EUROPEAN POLITICAL PROJECT AT A CROSSROADS?
With the comeback of Martin Schulz (SPD), the polls jumped 10 EXHIBIT 4: LATEST POLLS ON GERMAN VOTING INTENTIONS 40 35 30 25 20 15 10 5 0 Feb 16 Mar 16 May 16 Jul 16 Sep 16 Nov 16 Feb 17 CDU/CSU SPD Grüne FDP Die Linke Source: Forsa, J.P. Morgan Asset Management; data as of 15 February 2017. Conclusions The rise of populism has taken its toll in Germany, but certainly to a lesser extent than in fellow European countries. One obvious consequence is the further fragmentation of the party system. There is a significant probability that, for the first time in 60 years, the next Bundestag will be composed of six parties. Nevertheless, the risk of an anti-immigration, anti-european party being a part of a new government and directly influencing German and European politics is very low if anything, the populist risks lie more on the left side of the political spectrum. Although the odds currently still favour Angela Merkel to succeed, History might be on Martin Schulz s side. On February 12 Frank- Walter Steinmeier (SPD) was elected as the new president. Though the Presidential post is largely ceremonial, in the postwar period the result of that vote has been a surprisingly good bellwether for the future direction of German politics In contrast to the 2013 election, in which Peer Steinbrück (SPD) categorically ruled out a coalition with the far left party Die Linke, Martin Schulz (SPD) has so far kept this option on the table. A left-wing government formed by SPD, Die Linke and the Green Party would very likely lead to more active fiscal policy, higher taxation and more regulation. The impact on European politics could also be significant, as Martin Schulz was a strong advocate of Eurobonds and a European deposit insurance scheme. In the bond market, a left government should lead to a tightening in the Bunds-periphery spreads. A Merkel victory would likely have much less impact on financial markets and would be seen as business as usual. AfD FRANCE: NOT YET A DONE DEAL What s happening? On 23 April and 7 May 2017, the first and second rounds of the French presidential election will be held to choose the successor to François Hollande, who has decided not to run for another five-year term. If no candidate obtains an absolute majority at the end of the first round the most likely scenario the two candidates with the largest share of the votes will go to a second round run-off. In addition, on 11 and 18 June 2017, legislative elections will be held to elect the 577 members of the French National Assembly. While the legislative elections may seem less influential than the presidential election, they are still important, as having a majority in the National Assembly would significantly strengthen the new president s position. Who is running and what are their political positions? In France, as elsewhere in Europe, there has been a fragmentation of the political landscape in recent years, which has seen a weakening of the two major historical parties, the Socialist party on the left and the Republicans on the right, in favour of various other parties from across the political spectrum. Though many candidates will test their luck in the first round on 23 April, the current polls (Exhibit 5) suggest that only five candidates could play a key role: Marine Le Pen, the leader of the extreme right National Front, which has promised to withdraw from the EU if Le Pen is elected. Emmanuel Macron, a former economy minister who resigned in 2016 to start his own political movement, En Marche! Pro- European centrist and reformer. François Fillon, the candidate for the Republicans, who aim to reform the French economy in depth and restore fiscal balance, while remaining part of Europe. Benoît Hamon, the Socialist candidate, who represents the left wing of his party and whose policies include the creation of a universal basic income. Hamon is in favour of remaining in Europe, but wants to reform it. Jean-Luc Mélenchon, who is from the extreme left of the political landscape and advocates withdrawal from the EU. J.P. MORGAN ASSET MANAGEMENT 3
Marine Le Pen continues to lead in the polls for the first round of the French presidential elections while most of her opponents recently lost ground EXHIBIT 5: FEBRUARY POLLS ON VOTING INTENTIONS FOR THE FIRST ROUND OF THE FRENCH PRESIDENTIAL ELECTION 28 24 20 16 12 8 4 1 Feb 3 Feb 5 Feb 7 Feb 9 Feb 11 Feb 13 Feb 15 Feb Source: IFOP, J.P. Morgan Asset management; data as of 15 February 2017. Conclusions Marine Le Pen Francois Fillon Emmanuel Macron Benoit Hamon Jean-Luc Melenchon Francois Bayrou (not candidate) Although the consensus is that a victory for Marine le Pen is unlikely, the current fragmentation of the French political landscape means the probability is certainly not zero and could increase substantially under several plausible scenarios. If Marine Le Pen and Emmanuel Macron come out as winners of the first round, as the polls currently suggest, or if Francois Fillon manages to beat Emmanuel Macron, the National Front has, in theory, only a small chance of winning in the second round. In the past, in spite of good results in the first round, the National Front has never secured the presidency. As we have seen during the battle between Jacques Chirac and Jean-Marie Le Pen in 2002, other parties establish a front républicain which makes sure that left-wing voters vote for the right-wing candidate or the other way around. Most recent polls confirm that either Macron or Fillon would win in the second round against the National Front. However, the outcome would be far more uncertain if Benoît Hamon got to the second round against Marine Le Pen. Based on current polls, this seems unlikely, but he may seek an alliance with Jean-Luc Mélenchon which would, in theory, give him the potential to beat Emmanuel Macron and Francois Fillon. Mélenchon has so far refused an alliance with Hamon, though their programmes converge in some areas, but both know that an alliance is their only hope of victory. Such an alliance would result in a very uncertain second round, which would pit the extreme left and extreme right against each other. However, another alliance, announced just before publishing this paper, could strengthen the candidature of Emmanuel Macron. Indeed, Francois Bayrou, a centrist who was not a candidate, has decided to support Emmanuel Macron. As Bayrou is credited with 5 of intended votes, his support should give an edge to Macron against Francois Fillon and Benoit Hamon, whether or not he is allied to Jean-Luc Mélenchon. In conclusion, the French presidential elections are far from a done deal, and the uncertainties have increased recently. In this context, a Eurosceptic victory cannot be totally ruled out, although the probability remains low. The risk is sufficient to warrant vigilance, as a further deterioration in Franco-German relations - let alone a French exit from the EU - would have dramatic implications for Europe and for global financial markets. ITALY: ELECTIONS OR NO ELECTIONS? THAT IS THE QUESTION What s happening? The failure of Matteo Renzi s government to secure backing for its reform programme in the December 2016 referendum brought an end to Italy s ruling coalition. The No vote in the referendum also created a disparity in the electoral systems between the two houses of the Italian parliament, the House of Representatives and the Senate. In 2015, Italy s parliament passed an electoral reform law, widely known as Italicum. However, the law covered only the House, as it was widely expected that the referendum would approve Renzi s plan to greatly reduce the power of the Senate. The rejection of Renzi s reforms therefore creates an obstacle for future elections. In January 2017, the Italian constitutional court was required to pronounce a verdict of constitutionality on Italicum. The court approved the majority premium system, under which any party that wins 40 of the vote is awarded 55 of seats an important development as it potentially paves the way for more powerful and stable coalitions, reducing the turnover of governments that Italy has always experienced. However, it rejected the second-round system, under which another round of voting would have taken place if no single party was able to reach the threshold in the first round. Instead, the court ruled that if no party was able to reach a 40 threshold, no majority premium would be issued. This means that, in practice, the majority premium will very rarely be assigned due to the difficulty of reaching the necessary threshold in a single round of voting. 4 THE EUROPEAN POLITICAL PROJECT AT A CROSSROADS?
Who is running and what are their political positions? The decision of the court makes snap elections more feasible, but the situation is still fluid, and there are no binding effects from the verdict. For the time being, there are factors that increase the probability of early elections: The court declared that, following the abolition of the second round, the systems in the House and the Senate will be similar and early elections should be feasible. Both houses are close to a proportional system. In the Senate there is no majority premium and in the House the premium will be rarely attributed because the fragmented political landscape will make it very difficult to reach the 40 threshold, even with a coalition. Paolo Gentiloni s government, formed after Renzi s resignation, is the fourth government not directly elected in a general election (after those of Mario Monti, Enrico Letta and Matteo Renzi). Several political parties are therefore putting pressure on Italy s president, Sergio Mattarella, to call elections. But there also factors that make early elections less likely: Mattarella, the only figure that can dissolve Parliament, is not in favour of early elections, and has declared that reconciliation between the Senate and House electoral systems is a pre-condition for elections. The current government, under Gentiloni, can rely on a majority both in the Senate and the House, and could therefore continue its mandate until the natural end of the legislature in March 2018. Conclusions Economic frustration generated by the eurozone debt crisis has boosted Eurosceptic anti-establishment parties in Italy. According to the latest polls, the populist Five-Star Movement (M5S) would be a close contender to the leading Democratic Party (PD) gaining around 27 to the PD s 29 in the case of early elections 2. If an M5S candidate secured a mandate to form a government, it could usher in a very troubled political period in both Italy and in Europe. The M5S was born as a movement of protest and is against the establishment, against the euro and against Europe. The leader of the movement, Beppe Grillo, is a strong supporter of a return to the Italian lira and could call a referendum on Italian membership of European institutions, with serious implications for Europe s future. With the Italian political landscape still very fragmented, a new government under the leadership of a PD representative could be weak, resulting in another period of poor governance. As a result, Italy remains an area of political concern for Europe, and early elections would not be a market-friendly event in what is already an uncertain year. THE NETHERLANDS: A FRAGILE COALITION SEEMS MORE LIKELY THAN AN EUROSCEPTIC PRIME MINISTER What s happening? On 15 March 2017, legislative elections will be held in the Netherlands to select the 150 members of the Lower Chamber of Parliament and consequently the Prime Minister who will succeed Mark Rutte, who has been in the post since 2010 under two different coalitions. The Prime Minister is traditionally the representative of the political party that has won the highest percentage of votes. If this party does not have an absolute majority in parliament as is generally the case in the Netherlands it will have to form a coalition with other parties. Who is running and what are their political positions? The Netherlands has a proportional system of voting and there are no limits in terms of percentages of votes to access parliament; a party can be represented in parliament even with only one seat. In this respect, the Netherlands is perhaps the country that best illustrates the fragmentation of the political landscape in Europe, since 28 parties will contest the upcoming elections. A large number of parties may be a sign of a healthy democracy, but it complicates the process of the formation of a government. Since the fragmented landscape means that it is extremely difficult for a single party to secure an absolute majority in the Netherlands, it is generally a coalition that takes power. The sometimes diametrically opposed positions within these coalitions means they often prove to be unstable. Legislative elections usually take place every four to five years, but since 1945, there have been 29 governments in the Netherlands, which mean that the average duration of a government has been only 2.5 years. 2 Scenari politici, Demos, IXÈ. J.P. MORGAN ASSET MANAGEMENT 5
Observers paid little attention to this situation until the arrival in 2006 of a newcomer on the political scene: the Party for Freedom (PVV), founded by Geert Wilders. This party, which is Eurosceptic and anti-immigration, has seen a very rapid rise in popularity in recent years, thanks in particular to a more fragile social-economic situation since the crisis of 2008 (Exhibit 6). Building on its success in the 2010 elections, the PVV formed part of the coalition government of Mark Rutte, People s Party for Freedom and Democracy (VVD), along with the Christian Democratic Appeal (CDA). However, this coalition collapsed in 2012, due to deep divergences in views between the PVV and its partners, leading to early elections and the formation of a new government coalition, again led by Mark Rutte, but this time composed of the VVD and the Labour Party (PvDA). Conclusions If the polls prove to be correct, the PVV will win the elections. Since the Netherlands is a parliamentary monarchy, the King will have to mandate the winner to form a government. The latest polls give the PVV 27 seats, which would not give it an absolute majority. As such, it would have to form a coalition to govern. However, this goal would be difficult to achieve, given the sometimes extreme positions of the PVV and the fact that it proved to be an unreliable coalition partner in the 2010 government. Most political parties, including Mark Rutte s VVD, have already indicated that they would refuse to form a coalition with the PVV under Geert Wilders. If this is the case, the King would probably have to register the failure of the PVV to form a government and mandate the second political party by number of seats to form a coalition government. Although this would not be easy either, since it would involve perhaps-unnatural alliances between the left and the right, it has already been done many times in the past. Commentators therefore anticipate the formation of a government without the PVV that will keep the Netherlands anchored within the eurozone. Though the PVV of Geert Wilders is the highest party in the polls, it remains far from an absolute majority EXHIBIT 6: EVOLUTION OF NUMBER OF SEATS IN THE LOWER CHAMBER FOR MAIN PARTIES 50 45 40 35 30 25 20 15 10 5 0 1998 2002 2003 2006 2010 2012 2017 PvdA CDA VVD Democrats 66 GroenLinks SGP ChristenUnie SP PVV PvdD 50Plus Source: Lower Chamber, IPSOS, J.P. Morgan Asset Management; data as of 17 February 2017. 6 THE EUROPEAN POLITICAL PROJECT AT A CROSSROADS?
INVESTMENT IMPLICATIONS In a quieter political climate, investors would be seeing many good reasons to invest in eurozone equities, which stand to benefit disproportionately from higher global inflation and faster growth. The eurozone economy has just recorded its fifteenth consecutive quarter of positive growth, the unemployment rate has dropped to its lowest level since 2009, inflation is rebounding healthily and the manufacturing Purchasing Managers Index was at its highest level in more than 5 years at the start of 2017. The response of eurozone consumers to higher inflation will need careful watching, but in general we would expect these positive economic trends to drive a continued recovery in eurozone corporate earnings, which have many years of weak performance to make up for. However, while the economy is on a firmer footing, the political landscape gives more reason for concern. While we do not currently anticipate the election of a populist administration in this year s ballots, worries among market participants may well build throughout the first half of this year. The outlook for government bonds is also mixed. Concerns about future policy have already driven the gap in yield between French government bonds and their German counterparts to a multi-year high, and this trend is likely to continue until a new government takes shape in France. Investors looking to capitalise on the economic revival, while avoiding both the potential equity volatility and the increases in some government bond yields, may choose to consider the European investment grade and corporate bond markets for their regional exposure. J.P. MORGAN ASSET MANAGEMENT 7
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