(Bloomberg) -- Investors hoping for a reprieve from European geopolitical volatility in 2018 shouldn’t hold their breath. At the same time, a resulting weaker euro and price swings could mean better returns for equities.
While Europe isn’t due for nearly as many elections as this year -- when votes in Germany, the U.K., France and the Netherlands kept investors on their toes -- existing sources of political tension aren’t about to disappear, according to Roubini Global Economics and UBS Asset Management.
“The market’s experience, especially since Brexit, is not to underestimate political risks or the outcome of an election,” Guillermo Hernandez Sampere, head of trading at MPPM EK in Eppstein, Germany, said by email. “One way or the other, markets next year will not be as calm as this year. Some might say the next swan is already in the garage waiting to be painted black.”
A combination of a weaker euro, regional economic growth and political tensions could place European stock investors in a sweet spot, according to JPMorgan Chase & Co.
“Political uncertainty could somewhat cap the potential for an increase in the euro,” Emmanuel Cau, a global equity strategist at JPMorgan, said by phone. “If we see a combination of stronger economic activity and a weaker euro, that’s really good for European stocks.” The euro has gained 12 percent this year against the dollar, the most among major currencies.
Both the FTSE 100 and STOXX Europe 600 indexes have rallied this year, with U.K. stocks surging to a record and European shares at their strongest since 2015, boosted by improving earnings and macroeconomic growth. At a time of low volatility across developed markets, investors are grateful for idiosyncratic political events that trigger wider price swings, said John Roe of Legal and General Investment Management.
Equity volatility has been declining across developed markets, with the Vstoxx index of Euro Stoxx 50 volatility on track to record the smallest daily swings over the full year since 2012. Low interest rates, limited inflation and relatively mild volatility have helped to buoy developed stock markets in the years since the financial crisis.
Despite the concentration of political risks in the first half of 2018, their possible positive and quick resolution could bring further gains for European equities, according to Natixis SA. Over the next 12 months, European indexes could gain as much as 12 percent, especially if U.S. tax reform succeeds, Natixis analysts said.
“Though sources of political risk are numerous, we believe that recent developments offer the prospect of a rapid and powerful contraction in the political risk premium,” Natixis analysts Sylvain Goyon and Thomas Zlowodzki said in a note.
The Stoxx Europe 600 index traded 0.3 percent lower Thursday as the European Central Bank maintained its pledge to move slowly in winding down euro-area stimulus. The euro was little changed at 1.1837 against the dollar.
Here’s a round up of the biggest political events ahead and investors’ take on their impact:
Catalonia is preparing for elections on Dec. 21, as courts in Madrid investigate the leaders of the previous regional administration who staged an illegal referendum and then declared independence from Spain in October.
Roe of Legal and General Investment Management says he’s quite optimistic about Spain because it’s “in nobody’s interest” to see Catalonia default, especially since the Spanish state owns Catalonian bonds.
“Predicting the outcomes of political events is very tough, so instead we take a view on fair value under different outcomes and then focus on buying or selling where markets over-react or under-react to outcomes,” said Roe, whose firm bought Catalonian bonds after the referendum.
Italy will hold a general election in the spring of 2018, with concerns mounting that radical parties may gain ground amid discontent with economic policy, a record public debt load and an ailing banking system. The country’s anti-establishment Five Star Movement won the support of 27.5 percent of voters in an Ixe Institute opinion poll for Huffington Post published Dec. 10.
MPPM’s Sampere sees Italy as the primary political risk of the first half of 2018 and recommends reducing exposure to the nation’s assets in case parties opposed to the European Union win the majority.
“The euro mechanism could handle neither Ital-exit nor a default on government bonds or bank rescue,” Sampere said. “Such a scenario would have a major impact on markets.”
Still, the losses could be contained as most foreign investors are used to political churn in the country, said Max Kettner, a London-based cross-asset strategist at Commerzbank AG. “Italy would be an issue if we have populist forces coming to power, but that wouldn’t derail the market as a whole, that would only derail Italy.”
While the U.K. and the EU last week struck a deal to unlock divorce negotiations after months of stalemate, the question of Prime Minister Theresa May’s future has merely been delayed and trade talks promise to be the hardest part of the discussions. Paddy Power Betfair Plc offers odds of 6-4 on a 2018 general election.
Investors are split in their views on the impact of Brexit, with JPMorgan’s Cau saying the rest of Europe is “quite immune” to the break-up and Commerzbank’s Kettner warning that Brexit is “the big risk” for the European Union in 2018.
“All of the political crisis could have a quick and positive resolution aside from Brexit,” said Kettner, who is underweight U.K. equities and overweight Eurozone stocks.
Chancellor Angela Merkel has yet to form a government almost three months since she scraped home in the election. Her first attempt at an untried four-way alliance collapsed last month, and she is now trying to draw the Social Democrats back into government as her junior partners.
For Cau of JPMorgan, Merkel’s ability to form a successful coalition is the most important political factor in Europe in the medium-term because the rest of Europe depends on “strong” Germany to implement reforms.
However, as Commerzbank’s Kettner points out, German equity markets have brushed off political concerns and are up 4.5 percent since the Sept. 24 national election.
©2017 Bloomberg L.P.