European elections will take place from 22-25th May. Voters in the 28 members of the currency bloc will elect 751 members of the European Parliament (MEPs) for a 5-year term. We will look at potential outcomes from the election and analyse what they mean for markets.
What a difference 5-years make:
Since the last election in 2009 the sovereign crisis has changed the face of the Eurozone. At the peak of the sovereign crisis the fabric of the Eurozone was splitting at the seams. Greece was at risk of being thrown out, and the currency bloc was forced to decide how much responsibilities member states wanted to take for the fiscal mismanagement of their peers.
Although the crisis has calmed down since mid-2012 when ECB President Mario Draghi said he would do whatever it takes to save the EUR and German Chancellor Merkel seemed to prefer Greece within the Eurozone than without, this has come at a price.
In the last 2 years the EU has taken an increasingly large role in sovereign matters, for example the budgets of Eurozone members have to be submitted and approved by Brussels each year and banking union and regulation have been re-designed by the ECB. In one sense, this election will be a verdict on whether this trend towards centralisation is welcome, or not.
Watching out for Europe’s “Tea Parties”
Due to the post-crisis backdrop, this election could elicit a protest vote. Since 2009 virtually every country in the currency bloc and in the wider EU have had to undergo some form of austerity, with some more stringent than others. Thus, we are getting ready for the electorate to unleash a wave of dissatisfaction with the current EU status quo.
Minority parties in the Netherlands, the UK, France and Greece are all expected to do well in these elections, with France’s Front National, led by Marine Le Pen, and the UK’s UKIP, led by Nigel Farage, expected to beat their mainstream party rivals. The Netherlands’ Freedom Party is neck and neck with the ruling Freedom and Democracy Party, while Greece’s SYRIZA party has lost ground in recent weeks after the governing New Democracy Party managed to capitalise on a successful return to the bond market, falling unemployment and rising consumer confidence back to pre-bailout levels.
These parties may be diverse but they have some similarities including a desire to protect (or win back) national sovereignty and they tend to be hostile to immigration. While these parties are not expected to win more than 25% of the vote to make them a serious challenge to power in Brussels, they can be dangerous for national politics, as we have seen in the US.
The rise of the Tea Party in the US is a lesson for the currency bloc. Although the Tea Party does not have control of any of the major organs of power, it still has a loud voice in the halls of Washington. For example, the influence of the Tea Party is one reason why the government shutdown in 2013 lasted for so long and wreaked havoc on the markets.
Thus, the rise of Europe’s anti-establishment parties is dangerous for two reasons:
1) The power they could exert on national politics. For example, will a good showing for UKIP in the UK be a precursor to Scotland voting for independence in September? Could the mainstream parties panic and start to up their anti-EU rhetoric ahead of the 2015 general elections?
The same is true of SYRIZA in Greece, if they do well at the EU elections and also at the municipal elections that take place on the same day, they could agitate for a general election. A win for a populist party like SYRIZA, that is set on tearing up the terms of Greece’s bailout programme and quitting the Eurozone, could ignite the sovereign debt crisis 2.0 – this time bigger, and worse than ever.
2) The Dutch leader of the Freedom Party, Geert Wilders, has said that the anti-establishment parties should group together to become a force in Brussels. So far, this does not seem likely, especially with UKIP trying to distance itself from France’s Front National. However, if they win big majorities at these elections, the prospect of a pan-European anti-establishment party cannot be ruled out.
Reasons markets should be worried:
Below we rate the potential risks from these elections:
- Moderate wins for Europe’s anti-establishment parties: this would be the most EUR-friendly result, as it would suggest that problems at the national level could be avoided. Watch out for the Greek result, a win for the governing New Democracy party could be considered risk friendly as it would ward off the threat of SYRZIA in the medium-term.
- Big wins for anti-establishment parties: As we have mentioned, this could spook the markets as it could eventually elicit change at the national level. This is particularly important for the UK, which faces some major political risks in the next 12 months including the Scottish Independence vote in September and the general election in May 2015. This could trigger some risk aversion in the short-term, but the more dangerous risks, in our view, are more long-term in nature so any negative market reaction may be short-lived.
- Big wins for anti-establishment parties, who then group together: Wins for Europe’s Tea Parties, particularly in Greece, the Netherlands, France and the UK could trigger calls for an anti-euro establishment. Although bringing these parties together would take time, we think signs that a coalition of anti-euro parties could have the largest downward impact on risk assets.
The Market Impact:
EUR: the single currency has been remarkably resilient to political risk in the currency bloc over the last 18 months, for example, the FX market barely blinked during last year’s French and German elections. The single currency also has a negative correlation with peripheral bonds, as the risk premium for peripheral bonds has fallen, compressing yield spreads with Germany, the EUR has risen.
With peripheral bond spreads at multi-year lows, the risk is that they don’t fall further, which could weigh on the Euro. If the EU elections see a surge in support for the Tea Party then this could fuel political anxiety, which widens peripheral bond spreads (as risk premiums move higher) and weighs on the single currency.
As you can see in figure 1 below, the Spanish – German yield spread has started to move higher recently, which has coincided with a period of euro weakness. So it’s worth watching out for the results of this election to see if spreads widen further, if they do then this could hurt the single currency.
The euro could have a double whammy of downside risks including EU elections and an ECB rate cut. Thus, this could damage sentiment towards the euro and reinforce 1.40 as a medium-term top for EUR/USD.
Figure 1:
Equities:
European markets have moved in similar directions to the US markets and made multi-year highs in recent months. The prospect of election risks, do not seem to be a concern for the equity investors.
However, we think that European stocks could be at risk if the Tea Parties do well at the EU elections. Big wins for SYRIZA, UKIP, Front National and the Netherlands’ Freedom Party could trigger some capital outflows, as enhanced political risks put investors off the currency bloc.
If this happens then we could see risk aversion rise, helping to generate inflows into safe havens including US Treasuries, the Swiss Franc and the Japanese yen. The pound could also benefit, as it attracted inflows during the peak of the sovereign debt crisis in 2010-2012.
As you can see in the chart below, the EUROSTOXX index is pausing after a strong rally since mid-2012. One reason for this period of consolidation, which also coincides with the 50% retracement of the sell off from 2007- 2009, could be investors reducing their positions ahead of EU elections. Thus, the next move for Europe’s main stock indices could be dependent on the outcome of this weekend’s vote.
Figure 2:
Conclusion:
- The EU elections could trigger a protest vote after years of austerity post the sovereign debt crisis.
- Europe is experiencing the rise of its own “Tea Parties”, and although these parties are unlikely to cause havoc in Brussels they could put pressure on politics at home.
- The most immediate risk from the elections could be a win for Greece’s SYRIZA party, who has pledged to tear up the terms of Greece’s bailout programme if it gets into power.
- Wins for other anti-establishment parties, including Front National and UKIP in France, could see the mainstream parties become more anti-EU, especially in the UK in the lead up to next year’s general election.
- The market risk from these elections is high, as sovereign bond spreads have fallen to record lows in recent months as risk premiums have shrunk dramatically.
- The EUR has had a negative correlation to risk spreads – it has moved higher, as risk spreads have narrowed. Thus, if the election results trigger a widening of spreads, there could be enhanced downside pressure on the EUR.
- Equities may also come under pressure, and European markets are pausing for breath as investors weigh up the prospect of enhanced political risk.
- Voting takes place between 22-25th May and the results should be announced on 25th May. EU leaders are scheduled to meet at 1030 BST/ 0530 ET on 27th May to discuss the election outcome.
- Overall, watch out for volatility as a result of these elections.