Politics keep dominating the headlines. While in Italy the dust has settled a bit, at least for now, trade war fears increased again as President Trump did not back down from his tough line on trade.
This week central banks will be in the spotlight as well and markets will closely watch whether Mario Draghi will give a glimpse of the ECB’s plans of tapering its bond purchases.
Italian dust has settled, for now
With the installation of a new Italian government, markets have settled down somewhat. The assets which had been impacted most by the Italian political saga, Italian government bonds, equities and (European) credits, have retraced about a third of their movements. However, we likely have to accept that the theme of Italian political drama will not disappear anytime soon and that valuations of these asset classes will continue to embed a higher Italy-specific risk premium than before. We believe this makes sense. With the appointment of a more moderate finance minister, the probability that the new populist government will show some respect for the European fiscal rules has increased somewhat. However, market volatility can be expected to flare up on any announcement of large additional fiscal spending or any Eurosceptic tone from the new government. For now, an unconventional or “populist” government that might pursue unusual policy direction and create increased political tension within the Eurozone is a challenge which markets clearly prefer over a scenario of renewed elections in Italy.
Trade war fears flare up again
The impact of the Italian drama has been mostly limited to European assets. For global asset classes like equities and real estate, which have hardly moved on the Italian news, the other political theme, protectionism, will definitely play a bigger role. The US decision to levy tariffs on the EU, Canada and Mexico, and the announced retaliations from these trading partners will not have large and direct macroeconomic consequences. However, it raises significant risks of greater conflict ahead. The market has not shown too much concern so far, but this could change if the focus shifts to the bilateral talks between China and the US and the rising risk that NAFTA negotiations may fail. On 12 June also the historical meeting between Donald Trump and Kim Jong-un in Singapore is on the agenda.
For (geo)political risk factors such as Italian politics or the trade tensions between the US and many of its trading partners it will be crucially important how likely and how substantial the eventual outcomes will actually be for the real economy, not how much noise there is in the news headlines. Markets will look through the noise and will assess how substantial the real impact of trade talk, negotiation, adaptation in implementation and possible renewed talks will be. For now, the market’s opinion is that the damage will be contained. But, as we saw in Italy, things can change quickly. And if the facts change, the markets will change their minds.
A political crisis is not an economic crisis
One of the lessons learnt from the Italian turmoil is that a political crisis is not an economic crisis. Yet again it showed how important it is to appreciate the difference. Only when political turmoil starts to directly impact the real economy will politics have the “power” to do lasting damage to markets. A Eurozone break-up scenario would obviously create just that, as it immediately translates into a sharp tightening of financial conditions and a massive increase in uncertainty for households and corporates. Political turmoil that creates drama in the news headlines and (potential) long-term headwinds for trend growth or debt sustainability, however, does not fall into that category and will always have a much more modest (although not positive) impact on markets.
As said, the size of the impact of the various political risks on investor sentiment, risk premiums and asset class returns depends to a large extent on the economic and monetary environment we are in. As long as economic growth, earnings momentum and monetary support are in place, markets are better able to shrug off these fears.
Spotlight on central bank meetings
As far as monetary support is concerned, the spotlights will be on the central banks this week, as both the Federal Reserve and the ECB are gathering. For the Fed, the consensus is that the Fed Funds rate will be raised by another 25 basis points. The minutes of the Fed’s May Federal Open Market Committee (FOMC) meeting stated that most policymakers thought it likely that another interest rate increase would be warranted soon if the US economic outlook remains intact.
In the past few weeks, in which a flight to safety was visible as a result of the political turmoil in Italy, the market downgraded the expectations for Fed rate hikes (see chart below). In total one hike was priced out for the coming six months and another half a hike for the following six months. As calm returned, Fed expectations have risen again. There has almost been a continuous trend of slowly rising Fed rate expectations since September last year. In our view, this trend can continue and we do not see the recent market sentiment-induced reduction of market-implied Fed expectations as a trend changer. Our base case is that the Fed will hike rates once every quarter this year, followed by another three hikes next year.
Will Draghi keep his cards close to his chest?
The ECB meeting on Thursday will likely be more exciting than the Fed’s. The European central bank’s chief economist Peter Praet said the ECB would debate this week whether to end its asset purchase programme later this year. Also the German and Dutch central bank heads stated that there is no reason to continue the programme. The euro has been recovering from its Italy-induced weakness on increasing speculation that the ECB might announce as soon as this week that it will start winding down its bond purchases. Our base case is that the ECB will gradually taper its asset purchases to zero between September and December. As the ECB likely wants to retain some flexibility over the end date, we doubt that Mario Draghi will give many details already this week.
One of the reasons why Draghi may want to retain flexibility is the flare-up of Eurozone break-up risk, as Italian political developments also reflect on the Eurozone in general and expose its structural flaws, at a time that it is already coping with disappointing macro data and a rising risk of trade protectionism. In this respect, the EU summit at the end of this month in Brussels will be an important checkpoint. Strengthening of the Eurozone institutions and more burden sharing amongst the members of the Eurozone is needed. We may also get a better view on the attitude of Italian politicians towards the rest of the Eurozone: constructive or confrontational.