Calm Before The Storm In Europe?

by: Desmond Lachman

One has to be impressed by how calm financial markets are ahead of three important European elections scheduled for the end of May. For far from pricing in any tail risk that those elections might bring unwelcome consequences in their wake, markets seem to be choosing to totally ignore those upcoming elections. And they do so despite many reasons to think that those elections might not go as smoothly as the market seems to be anticipating.

Perhaps the most important of those elections is the Ukrainian presidential election scheduled to take place on May 25. It should be clear by now from his recent actions that the last thing that Vladimir Putin would like to see is a legitimately elected Ukrainian president. Over the next month, this will, in all probability, incentivize him to use all the many levers at Russia’s disposal to destabilize Ukraine in the run-up to those elections.

The Ukrainian risk that the market seems to be underestimating is that we might now be on a path of escalating sanctions against Russia. Such sanctions might in the end include financial sector sanctions, which, while they could be very effective against Russia, they could also have unintended consequences for the international financial system. This would seem to be all the more so the case considering Russia’s relative importance as a trading nation. We might also be on a path where Russia retaliates with restrictions on its natural gas exports to Europe, which account for around 30% of Europe’s overall natural gas needs.

A second area of political risk that the market seems to be ignoring is the European parliamentary election scheduled between May 22 and 25. This is all the more surprising considering that the electoral polls suggest that the anti-European vote might rise to as high as 31% in those elections. It is also surprising considering that populist parties might come in first at the polls in countries like France, Italy, and the United Kingdom. One would have thought that markets would be concerned about the boost that such an outcome might give the growing anti- European sentiment across the continent.

Yet a third area of risk that the market seems to be discounting is the Greek local elections scheduled to take place in two rounds on May 18 and May 25. This too is surprising considering that Syriza, the extreme-left Party, continues to hold a narrow lead in the polls over the New Democracy Party of Prime Minister Samaras. A loss by Samaras at those elections could cause his very fragile coalition government to fall, which could in turn raise serious questions as to Greece’s political willingness to persevere with its economic adjustment program.

To be sure, it could turn out that all of the risks alluded to above might not materialize. However, one would have thought that at a minimum the markets would have priced in a small probability that those risks could materialize. If indeed those risks were to materialize, it would not be the first time that markets were blindsided by events that were all too easy to anticipate.