Despite real economic challenges, the risk of a significant recession in Europe remains low -- barring monetary, fiscal or banking policy mistakes in the wake of the EU elections.
UK political turmoil (again)
The resignation of UK Prime Minister Theresa May last week, is something that has been coming since she failed to win a majority in the 2017 general election. With no electoral mandate she tried to find an answer to the UK’s greatest political dilemma for 50 years. It was always going to be an impossible task as all sides were able to take advantage of her position and ensure whatever she did, would end in failure.
What will happen now is a new leader will try and find a consensus in the UK parliament for a solution. Whether the EU agrees to that solution is another matter. If they cannot, or the EU rejects it, then it will have to return to the electorate, either in the form of a general election, or less likely, another referendum. This raises the prospect of a ‘Hard Deal’ Brexit, which the market is conscious of. It also raises the prospect of a win for the Labour Party, which would not be perceived as business or debt friendly and thus it would not be viewed as a market-friendly government. As such, you would expect the currency to weaken and UK assets to price in this risk. Oddly they are not. As we are in a period of political chaos and uncertainty, the risk to the downside is clear and only when the new leader of the Conservative Party is named, will that begin to be priced in.
The outcome of the EU election looks more dramatic than it is: the narrative was supposed to be a nationalist surge but, with the exception of Italy, this has not happened. While the centre-right groupings in the EU have been weakened, they are joined by the Greens and Liberals who are even more pro-European integration. There will be a battle for the top jobs but expect them to go to solidly pro-European officials who can create a working consensus. The most important position for the markets is the new head of the European Central Bank (ECB). The appointment of the president of the Bundesbank, Jens Weidmann would create uncertainty and an element of fear, in particular for Italian debt spreads and the banking industry.
What happens next?
After the dust has settled from the European election, we will see a return of focus to other pressing issues. There is a major industrial/manufacturing slowdown that is persistent and broad. Many think this is caused by the US/China trade wars, but as it started in the second half of 2018, it pre-dates this. If this spreads to the service sectors, then a greater slowdown than we are already seeing will emerge. This will put real pressure on the politicians in the high-debt nations of Europe to try to offset it via fiscal means which the EU may oppose. It will put pressure on the ECB to renew quantitative easing, something that would be opposed by Germany. The risk of a significant recession (similar to 2008/9) is not great and we may already be in a mild one. However, the risk of policy mistakes making it deeper via monetary, fiscal or banking is real.
Caution and opportunity
So, for now we remain very cautious: in fact the risk (and thus for us the opportunity) is to the downside. So, if markets pull back substantially, there will be an opportunity to buy. Then we will have a view of a new cycle emerging. June is historically the worst month of the year for European equities and all the evidence is it will live up to expectations.
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