After Italy: Forget politics – it’s the economy, stupid


  • The investor message from Italy was: forget politics, watch monetary policy and the economy
  • With the Fed set to tighten faster, we still call for the Euro to fall 20% – helping US stocks outperform for European investors
  • Among next year’s elections, France’s has the greatest potential to move markets – and it could be in a good way

The most important poll result in the last two weeks may turn out to be neither the “No” in Italy, nor the defeat of the far right in Austria. Instead, the key event may have been Francois Fillon’s nomination as the French Republican party’s candidate in next year’s Presidential election.

The Italian vote sets back the process of reform, in both the structural sense of failing to streamline the Senate and the tactical sense of obstructing bank re-financing and removing a leader committed to overhaul of taxes and local government. These are negatives for Italy and in the long-term may make the country a less stable member of the Eurozone, but in political terms, the result looks boringly like business as usual. There is yet another change of government, yet another weak coalition muddling through, and yet another electoral law change, this time to contain the populist 5-Star party. Equally, the Austrian vote does not give the sense of a major political watershed. Norbert Hofer gained over 46% of the vote, suggesting that his Freedom Party remains a major political force despite its defeat on this particular occasion.

By contrast, Mr. Fillon’s victory has the potential to produce a genuine shift in French politics and perhaps ultimately help the economy. There are many stages ahead: the Presidential election next Spring, the parliamentary poll, and then potentially years of struggle over economic reforms. But there is a sense of broad coalition-building across social conservatives who might otherwise vote for Marine Le Pen, and also disgruntled voters of left and right who have lost from the current system, and might benefit from reform. After all, it is a reformer, Manuel Valls, who is most popular among candidates for the Socialist nomination, so if as expected he drops out of the first round of the Presidential election, quite large numbers of his supporters may switch to Mr. Fillon in the key second round.

Politics can thus give plenty for investors to think about and debate, and cause occasional surges of excitement in markets. But with so little clarity the effects are likely to be short-lived, though perhaps not always as breathtakingly short as the reaction to the Italian referendum. This saw sell-offs that lasted about 6 hours in foreign exchange and less than 6 minutes in equities. Indeed, looking back over history, it is normal for the market reaction to major political and geopolitical events to be reversed rather quickly, unless there is a real prospect of a lasting economic impact. Sharp US stock market falls after 9/11, for example, were unwound within weeks. This year, the sustained weakness of the British Pound following the Brexit referendum has been an exception to this pattern, but can be attributed in part to Mark Carney’s aggressive monetary easing. And it is too early to know if the broad equity strength in response to Donald Trump’s election will be long lasting – it likely depends on whether the promised major fiscal expansion materialises.

In Europe, the upcoming political event most likely to have lasting economic impact is the French election – and that might just be in a good way, if Mr. Fillon wins convincingly. Even then, many investors will wait for evidence that he can deliver. That aside, it would take a major upset for other elections to shock markets, with a messy coalition expected in the Netherlands and a weakened Angela Merkel seen still leading Germany.

So, with European politics likely to have mainly short-term impact on markets, what will investors focus on instead? The answer is likely to be monetary policy, and of course the actual performance of companies and economies. The gap between Eurozone and US monetary policy is set to widen, as the ECB stays on a relatively expansionary path while the US Fed goes the other way, accelerating its tightening programme in response to a robust economy that is further stimulated by Trumponomics. This can drive the Euro much weaker, even absent political turmoil, possibly down another 20% against the Dollar. And that is likely to be quite stimulating for the European economy and stock markets, although measured in Euro terms, an unhedged investment in US equities has the potential to do even better.

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