Political risk, once regarded as the preserve of emerging markets, is now arguably the biggest threat to investors in the developed world. Following ‘Brexit’ and Donald Trump’s victory in the US, attention turns to Europe, where a series of pivotal elections will take place over the next 12 months.


Europe, November 2017. Picture the scene.

Angela Merkel has been re-elected as German chancellor, but her power has been curtailed by the entry of several new minority parties into the German parliament, including the Eurosceptic Alternative für Deutschland (AfD). Speaking in the Bundestag, Merkel argues that Germany should take in more refugees from the escalating war in Syria – but is shouted down by her far-right rivals.

President Marine Le Pen, who won a surprise victory during the French election run-off in May, launches her campaign for a ‘Leave’ vote at the country’s upcoming referendum on European Union membership. Le Pen is cheered from the side-lines by her ally Geert Wilders, the new Dutch leader, who is trying to take his own country out of the bloc.

To the south, Italy is mired in political turmoil. Twelve months after Italian Prime Minister Matteo Renzi resigned following a failed attempt to convince voters to support his plans for constitutional reform, Beppe Grillo’s increasingly powerful Five-Star Movement is railing against a technocratic interim government and demanding a referendum on the euro.

And as Europe’s embattled centrists fight a rear-guard action against the breakup of the EU, Russian troops are massing along its European borders, prompting fears Vladimir Putin is ready to test NATO’s willingness to defend the Baltic states after the withdrawal of US support under President Trump.

Uncharted territory

This, at least, is one of the bleaker hypothetical scenarios for Europe in 2017.

Over the next 12 months, a series of potentially pivotal elections will determine the future course of the EU. The stakes are high. Voters may reject populism and elect leaders who will further the project of European unity. Or an anti-establishment revolt – a phenomenon political scientist Francis Fukuyama has called a ‘new populist-nationalist internationale’[1] – may sweep the continent, leaving the current liberal consensus in tatters.

A string of victories for populist leaders in Italy, France, the Netherlands and Germany is unlikely, but not implausible. The UK’s decision to leave the EU and Trump’s victory in the US presidential election were also considered low-probability events by many market participants, and they wrong-footed political pundits and financial markets alike.

“The demise of political centrism has been marked and shocking over the last 12-18 months,” says Trevor Leydon, Head of Investment Risk and Portfolio Construction, Multi-Assets, Aviva Investors. “Political risk is something that we had almost become unfamiliar with in the developed world. But it’s a growing threat, and as an industry we have not been good at pricing it. For an entire generation of financial professionals, this feels like uncharted territory.”

The ‘Brexit’ vote demonstrated the impact that unexpected political events can have on the financial markets. The FTSE 100 and 250 stock indexes fell sharply after June 23, before gradually recovering.  Sterling, on the other hand, fell to a 30-year low against the dollar in the days following the vote and remains far below pre-referendum levels.

US stock markets were relatively calm following the Trump victory, but Treasury yields have begun to rise, with the benchmark 10-year yield topping two per cent for the first time since January. While the president-elect has previously threatened to default on US debt, it is more likely that the rise in yields is the result of fears his protectionist policies will stoke inflation. Goldman Sachs has warned a Treasury sell-off may be “potentially destabilising for broader markets”.

So how would the financial markets react if European populists followed Trump’s lead and swept to power over the next 12 months? And what steps can investors take to protect their portfolios amid political upheaval?

Coming unstuck

The Austrian presidential election, scheduled for December 4, will give an indication of which way the political winds are blowing in Europe. The election will be contested by Alexander Van der Bellen, an independent backed by the centre-left Green Party, and Norbert Hofer of the Freedom Party. Hofer has called for strict border controls and previously advocated a referendum on EU membership, although he now says he favours remaining in the bloc.

The election is a repeat of a vote that took place in May. Van der Bellen narrowly won the first round, but the result was annulled amid complaints of anomalies in the counting process – the glue on the envelopes containing postal votes failed to stick, invalidating thousands of ballot papers – and Hofer is now the favourite. His expected victory may be largely symbolic, as the Austrian president wields little executive power, but it may be a sign that the political status quo in Europe is itself coming unstuck.

December 4 is also the date of a much more significant political event: the Italian referendum. The vote concerns amendments to the Italian constitution put forward by Prime Minister Matteo Renzi of the centre-left Democratic Party. Renzi says these changes will curb the power of the Senate, simplify decision-making and streamline the political process. Opponents of the bill, including the Five-Star Movement, the right-wing Northern League and Silvio Berlusconi’s Forza Italia party, say the amendments will reduce checks and balances.

Renzi has effectively staked his future on the outcome. Earlier this year, he pledged to resign if the referendum fails, and though he has since backtracked on that statement, the vote has come to be seen as a plebiscite on his leadership. Renzi is increasingly unpopular – he is grappling with youth unemployment of 40 per cent and escalating public debt – and opinion polls suggest the ‘No’ camp has the lead. Deutsche Bank economists foresee a 60 per cent likelihood of a ‘No’ vote.[2]

If Renzi were to resign it is likely that an interim government of technocrats would step into the breach, as was the case following former Prime Minister Berlusconi’s resignation in 2011; the next general election is not due to take place until 2018. Nevertheless, a ‘No’ vote would be considered a victory by the populists, particularly Grillo, a former comedian and television personality who has said Trump’s election shows that it is “we…the barbarians” who will “take the world forward”[3]. Both the Five Star movement and the Northern League have called for a referendum on Italy’s membership of the single currency.

The financial markets are already reflecting fears that Italy will be destabilised by a ‘No’ vote, with the benchmark FTSE MIB index down more than 23 per cent between January 1 and November 25. “You’ve seen quite a big underperformance in the Italian market this year relative to other markets in Europe, and that has to do with the uncertainty surrounding the referendum,” says Edward Kevis, European Equities Fund Manager at Aviva Investors. “The outcome could have a big impact on the equity markets.”

Rise of the far-right

On March 15, 2017, the Netherlands will elect a new prime minister. For much of 2016, Geert Wilders, leader of the nationalist Freedom Party, has been leading in the polls despite facing an impending trial for inciting racial hatred, although more recent polls suggest he is neck-and-neck with Mark Rutte of the ruling People's Party for Freedom and Democracy. Wilders says he would hold a referendum on the Netherlands’ membership of the EU if he is elected.

Wilders’ far-right ally Marine Le Pen will contest the French presidential elections in April and May 2017. Many of her probable opponents are still jostling for position within their respective parties. The current favourite is former Prime Minister François Fillon, who has beaten rivals Alain Juppé and Nicolas Sarkozy to win the nomination of the centre-right Republican Party. The incumbent, François Hollande, is eligible to run for a second term, although his approval ratings have plunged and the Socialist party may be tempted to field an alternative candidate.

Early opinion polls suggest Le Pen has enough support to make it through the run-off vote in May, following in the footsteps of her father and predecessor, Jean-Marie Le Pen, who was well beaten by Jacques Chirac in 2002. In regional elections in December 2015, FN candidates failed to win control of any region despite a surge in their overall share of the vote, because the centre-right and centre-left parties collaborated to defeat them. Centrist parties would probably repeat those tactics if Le Pen came through the early rounds of the presidential election.

Nevertheless, a far-right triumph in France looks more likely following Trump’s election in the US: Le Pen has welcomed Trump’s victory and says it boosts her own chances. Le Pen is arguably the greatest threat to the integration of the EU over the next 12 months. Although she has softened the FN’s image, throwing out colleagues who espouse more hardline views (including her father), she is vociferously opposed to the EU’s freedom-of-movement principle and has pledged to hold a referendum on France’s membership if she wins.

Le Pen would therefore present a danger to EU integration. The French bond markets may already be reflecting the increased risk of a Le Pen presidency following the US election result. On November 11, France’s 10-year government bond yields rose to 0.75 per cent, 25 basis points higher than before Trump’s victory.

Merkel’s last stand?

Germany will hold its federal elections in September and October 2017. Angela Merkel’s Union coalition enjoys a large majority in the Bundestag and, having announced her decision to stand for re-election as Chancellor on November 20, she will probably remain in position. The crucial question concerns the extent to which her power will be constrained by the entry of AfD and other minority parties to the Bundestag.

The AfD has criticised Angela Merkel’s stance on immigration; particularly her decision to welcome large numbers of Syrian refugees, and the party’s recent performance in state elections indicates its tough rhetoric may have resonated with the electorate. AfD leader Frauke Petry has not openly demanded a referendum on EU membership, and the German constitution allows referendums in only two circumstances: constitutional reform or changes to state territory. The AfD may press instead for reform of the EU system, which it has called a “quasi-socialist experiment”.

Merkel has repeatedly cancelled meetings with other EU leaders in 2016 as she tries to shore up the CDU vote against the rise of the AfD and other anti-establishment parties, which may indicate her capacity to act as the EU’s de facto leader could be curtailed after the election. And if the EU principles of free trade and free movement came under threat, the impact on the financial markets would be profound, says Leydon.  

“Whether people like the idea or not, the European project is incredibly important to the European economy. The principles of free trade and free movement of people have been of enormous economic gain for everyone. If you make an Airbus plane, for example, you get your wings from the UK, your fuselage from France, Germany and Spain. Putting up borders and tariffs would be a massive economic hindrance.”

And that’s without factoring in the more damaging prospect that the increasing power of the Five Star Movement and the AfD could bring the single currency itself into question. “If people voted to break up the euro they would unleash forces that no national government could control,” adds Leydon. “Take a German pension fund domiciled in Luxembourg. Would investors in that vehicle receive their capital in Deutschmarks or Francs? These sorts of problems would be near-impossible to untangle.”

Investment implications

For now, a breakup of the single currency looks like a remote prospect. And if cracks began to show in the political unity of the EU, institutions such as the European Central Bank (ECB) would play a role in keeping a lid on market volatility. The ECB’s quantitative easing policies have arguably contained some of the economic damage that would otherwise have been unleashed by the populist one-two punch of Brexit and the Trump election.

But there may be a limit to how long the bank can maintain its accommodative stance – especially as it and other central banks across the West have taken flack from populist politicians for fuelling asset prices and exacerbating inequality.

“If the ECB extends easing, albeit in a tapered fashion, that may contain some of the spill-over effects of political upheaval,” says James McAlevey, Senior Portfolio Manager, Fixed Income at Aviva Investors. “But the timing is quite interesting, because the easing programme is due to end while these elections are taking place. Mario Draghi may seek to extend the easing programme, but we’re coming to an inflection point as to what central banks can do.”

With so many variables in play, it is difficult to quantify the potential impact of a populist surge in Europe. A political risk index developed by the economists at French insurer Compagnie Française d'Assurance pour le Commerce Extérieur (COFACE) estimates that Europe’s top five economies could suffer a drop in GDP growth of 0.5 per cent over 2017 purely due to uncertainty surrounding the forthcoming votes, even before negative outcomes are factored in.[4]

Different political outcomes will have implications for specific asset classes. Take the Italian referendum. In a scenario cited by Deutsche Bank, in which a ‘No’ vote prompts the fall of Renzi and ushers in a populist government, the benchmark FTSE MIB Italian stock index would fall more than 15 per cent between December 2016 and January 2017 – and even further if a euro referendum is announced.

Banks would lead the sell-off due to fears of knock-on effects across the weakened Italian banking sector. For example, political upheaval would obstruct attempts to remedy the problems afflicting Monte Dei Paschi, a heavily indebted lender that is currently trying to woo foreign capital for a €5 billion recapitalisation plan. The uncertainty surrounding the referendum appears to be keeping many investors away. A government bailout of the bank is an option, but EU state aid rules prohibit state support without inflicting losses on bondholders – politically difficult in Monte Dei Paschi’s case, as this would hurt many ordinary Italians who have invested in the bank.

“The fundamentals of banks are driven by politically-influenced factors, such as interest rates, which make the political context important. The uncertainty is driving financial stocks up and down,” says Kevis. “Other cyclical, domestically-exposed sectors, such as car manufacturing, would underperform following a ‘No’ vote in the referendum, while investors will likely prize perceived ‘defensive’ names in consumer staples – where valuations are already high – and companies with international exposure.”

As well as modelling the impact of political events on companies and sectors, it will be important for investors to pay attention to capital flows across European markets. In France, for example, the high proportion of foreign investors in the bond market may have repercussions in the event of a Le Pen victory.  As global bond yields have declined in recent months, overseas investors have sought out French debt because it offers a pick-up in yield over other European countries such as Germany. If those investors flee, the market could become increasingly volatile, generating both risks and opportunities for investors.

“Foreign ownership levels in the French bond market have escalated recently, especially among Asian investors,” says McAlevey. “Overseas investors have bought French bonds because they offer 10-30 basis points more than Bunds. But the risk of political contagion hasn’t fully been priced in. If the far-right comes to power in France, you could potentially see capital flight and a rise in yields.”

Relative havens

What is clear is that portfolio managers must now pay closer attention to political events than at any time since the end of the Cold War. Political insiders – or ‘interpreters’ – will become more highly prized as advisors to investment organisations.

As political risk spreads, deeply-held assumptions about the stability of politics in developed markets – and their status as ‘safe havens’ – are beginning to unravel. Exposure to different asset classes, and the flexibility to respond adroitly to a changing political and macroeconomic backdrop, will be crucial if investors are to ensure their portfolios are resilient.

“It’s time to speak of the ‘relative safe haven,’” says Leydon. “If European political risk escalates, would you flee to a Donald Trump America, even if he is threatening to default on Treasuries? Or would you look to Switzerland, or Germany? In an environment where the risk profile of safe havens is liable to change, diversification will become more important, as will the flexibility to execute a range of strategies.”

So what would be the implications for investors if our hypothetical scenario plays out, with Renzi defeated, Le Pen triumphant and Merkel weakened? “We do not expect the doomsday scenario to happen,” says Leydon. “But while it is unlikely, it is not to be dismissed lightly. Politicians campaigning on a protectionist and national self-interest agenda are winning favour around the globe. If that trend continues in Europe, it would lead to a fundamental change in the way investors see the notion of sovereign risk and how they plan for the future.”



[1] ‘US against the world?’, Financial Times, November 2016

[2] ‘Italy’s referendum and beyond,’ Deutsche Bank, November 2016

[3] ‘Trump's triumph puts Italy's Renzi in difficult position,’ Reuters, November 2016

[4] ‘European economies: will political risk spoil the party in 2017?’, COFACE, October 2016

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at November 25 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.