Again and again : political news in the US and Europe

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Trumponomics in 2016 gives way to Trumpidation in 2017

The key worry for many in the markets following Donald Trump’s entry into the White House was that election promises on trade barriers and immigration restrictions would ultimately hold back economic growth and outweigh pro-growth Republican party policies including deregulation and higher infrastructure spending.

Exhibit 1: Changes in US consumer and small business confidence between 2003 and June 2017


Source: Bloomberg, BNP Paribas Asset Management, as of 06/07/2017

In fact, we have had relief and disappointment in equal measure: President Trump has fortunately so far not been allowed to follow through on such policies, while the Republicans have failed to achieve much of their own pro-growth agenda.

Many investors still believe, however, that the party will pass and implement at least some of its policies, which may explain why US equity markets have maintained their post-elections gains.

That said, much of the initial enthusiasm has faded, resulting in inflation expectations falling back to pre-election levels.

Exhibit 2: Expectations of the future level of US inflation have fallen back to pre-election levels (graph shows changes in the USD Inflation 5 year swap, 5 years forward)


Source: Bloomberg, BNP Paribas Asset Management, as of 06/07/2017

We share the cautious optimism about the potential for the eventual passage of tax reform, fiscal stimulus and deregulation, but with equity markets still up by around 12% since 8 November, the likelihood of additional market gains is modest.

It is, moreover, quite possible that the Trump administration’s current political problems  distract the Congress to the point that it is unable to pass any of the more significant initiatives, such as healthcare or financial sector deregulation. Additional disappointment would likely depress what are currently very high multiples for equity markets.

The GDP growth rate of the US economy was disappointing in the first quarter, and inflation continues to come in below expectations. Futures markets are still forecasting fewer rate hikes by the US Federal Reserve (the Fed) than the central bank itself has laid out.

Nonetheless, US Treasury yields appear low to us and we anticipate that they will rise over the rest of the year. The tightness of the labour market should eventually prompt employers to raise wages, and there is little excess capacity in the US economy. The Fed believes it needs to raise interest rates to ‘normalise’ policy, even though many investors worry this could be a policy error that risks derailing the recovery.

There are equivalent worries in Europe, that further tapering by the ECB could snuff out the much delayed spurt of growth in the eurozone. While forecasts of 1.7% for 2017 are above the potential GDP growth rate of the economy, there are still many indicators (credit growth, unemployment) that suggest it is not a vigorous expansion. The worry is that rising yields, particularly in the eurozone ‘peripheral’ countries, could provoke a renewed bout of anxiety over the long-term viability of the currency union.

The experience of the US and the UK, however, when they finally ended their quantitative easing programmes, would seem to show that GDP can continue to expand despite a withdrawal of central bank support. Low yields in the eurozone over the last two years seem to have done little to boost bank lending, so it may be that slightly higher rates will equally cause little harm. In fact, there are benefits to higher yields, at least for savers and banks, and to the degree that a more hawkish ECB signals confidence in the eurozone’s recovery, business and consumer sentiment should improve as well.

Eurozone equities have outpaced those in the US so far this year, and we expect that pattern to continue. It is well known that valuations are higher for US than for eurozone equities, while the outlook for earnings growth is more positive for the eurozone. The best that one may be able to hope for in the US is earnings growth without price appreciation, allowing the multiple to compress, while in Europe both earnings and valuations have room to rise.

Exhibit 3: Relative performance of US (S&P 500 index) and European (Eurostoxx 300) equities (in local currencies) from 01/01/17 through June 2017


Source: Bloomberg, BNP Paribas Asset Management, as of 06/07/2017

Eurozone assets and the political context: Italy is the one to watch

The election of populists in eurozone countries was avoided in the first half of 2017. As we consider whether this is likely to affect eurozone assets in the coming six to 12 months, we must recognise that Italy remains a major risk.

Italy’s finances deteriorated significantly during the Global Financial Crisis (its debt as a percentage of GDP rose from 100% to 133%). In most of the countries in the eurozone, GDP growth is improving but in Italy it is decelerating. Add to this mix a central bank which is reducing monetary support and a populist, euro-sceptic political party leading in the polls and the prospects are worrying.

Even if we believe the odds are very low that Italy would actually exit the eurozone, we know from Greece that political uncertainty can still cause significant turbulence in financial markets. Merely the prospect of early elections contributed to a near 10% decline in the MSCI Italy Financials index in May this year. European equities were broadly resilient during the French elections even as spreads on French government bonds reached their highest levels since 2012. Problems in Italy may have wider implications as the odds are higher of an anti-euro outcome, the debt burden is greater, and the banking sector is less solid.

Besides equities, the asset that will most immediately reflect worries about the outlook will be Italian (and other ‘peripheral’) government bonds. While spreads on French government debt have halved since the election of President Macron, in Italy they are approaching year-to-date highs. We are confident that the eurozone will remain intact, all the more so now with wins by pro-European parties in the Netherlands and France. But most of the challenges facing the eurozone, from the need for a banking union to greater fiscal transfers, remain. These are still likely to prompt bouts of market volatility in the months ahead.

Exhibit 4: Risk premia for French, Italian and Spanish government debt relative to German government bonds (10-year yields)


Source: Bloomberg, BNP Paribas Asset Management, as of 06/07/2017

Written on 06/07/2017

Daniel Morris

Senior investment strategist, CFA charterholder

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