Investors In Europe Beware Problematic Politics

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Includes: ADRU, BBEU, DBEU, DBEZ, DBUK, DEUR, DEZU, DRR, EDOM, EEA, EPV, ERO, EUFL, EUFN, EUFX, EUO, EURL, EWU, EWUS, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, FKU, FLEE, FLGB, FXE, GSEU, HEDJ, HEWU, HEZU, HFXE, IEUR, IEV, PTEU, QGBR, RFEU, UEUR, ULE, UPV, URR, VGK
by: Elga Bartsch
Summary

Heightened concerns about Europe's future would likely lead to a renewed widening in peripheral eurozone government bond spreads.

The BlackRock Geopolitical Risk Indicator shows that investors are keeping a keen and wary eye on the risk of European fragmentation - it is the most prominent geopolitical concern for financial markets at the moment.

It is not surprising that Europe is becoming increasingly under-owned.

Elga explains why politics pose the biggest risk to our base case that European growth should rebound in the second half of this year - and why the European Central Bank's perceived lack of policy options is also a concern.

We expect eurozone growth to pick up in the second half of this year. But the risks around our favorable base case are considerable - and they are mainly tied to potential political troubles.

The UK has bought more time to hammer out a Brexit agreement, but uncertainty remains. There may be renewed escalation of the trade tensions between the U.S. and EU, centered around car tariffs. U.S. President Donald Trump has until May 18 to decide whether to take action against European car producers on national security grounds. And European Parliament elections in late May could result in a populist sweep of protest parties from both ends of the political spectrum. This would further erode the influence of pro-European centrist political forces.

Heightened concerns about Europe's future would likely lead to a renewed widening in peripheral eurozone government bond spreads. See the Eyes on the wides chart below. The 2020 budget season may refocus attention on the conflict between the Italian government and the European Commission. There are also going to be leadership changes this year in many EU Institutions, including at the ECB. The BlackRock Geopolitical Risk Indicator shows that investors are keeping a keen and wary eye on the risk of European fragmentation - it is the most prominent geopolitical concern for financial markets at the moment. It is not surprising that Europe is becoming increasingly under-owned.

Assessing the ECB's options

We believe the ECB should pause further steps towards policy normalization for the remainder of this year - and likely beyond - to ensure a return of inflation to its below-but-close-to 2% price stability objective. At the upcoming meetings, the Governing Council will set the conditions for further long-term loans to banks (TLTRO3), discuss tiering of reserves and review its monetary stance. While a further extension of forward guidance would likely be the first line of defence, additional policy action is also becoming more likely. The continuation of ultra-accommodative ECB policy is reassuring for near-term growth. But the perceived lack of policy levers to counter any future downturn could rattle markets in the long term.

ECB President Mario Draghi could complete his eight-year term without once tightening policy. It is not clear whether his successor will get an opportunity to raise rates from -0.4% before the next downturn. If the next ECB policy move is to ease, there won't be many options left in the monetary toolbox. In this situation, the ECB could either lift self-imposed constraints on its government bond purchases - the Public Sector Purchase Program (PSPP) - or move into new asset classes, such as equities or bank bonds, or push market interest rates even lower through rate cuts or forward guidance. Yet, all of these options would likely face considerable opposition on the Governing Council.

This post originally appeared on the BlackRock blog.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.