Developments in Europe, including the resignation of Italian Prime Minister Matteo Renzi and the shock decision of the European Central Bank to reduce the amount of its monthly bond-buying program next year, have contributed to a tumultuous week for investors. Here David Zahn, head of European fixed income, Franklin Templeton Fixed Income Group, offers his analysis of these situations and explains why he sees a silver lining in both instances.
David Zahn, CFA, FRM
Head of European Fixed Income
Senior Vice President, Portfolio Manager
Franklin Templeton Fixed Income Group
Politics has dominated many global investors’ concerns for the last six-to-12 months, and nowhere more so than in Europe. While I think it’s important to continue to look at the underlying fundamentals, I maintain that politics and monetary policy will be the most important drivers of financial markets over the next year.
For that reason, we were eagerly anticipating the latest pronouncements from the European Central Bank (ECB). Its announcement included confirmation that the ECB intends to extend its asset-buying program until the end of 2017, but to reduce the monthly purchases in April of next year to €60 billion from the current €80 billion.
Initially, a number of investors seem to have assumed this move amounts to a tapering of the program. We have a different view.
The absolute amount the ECB is now expecting to purchase over the lifetime of the program has been increased. In addition, we believe that by removing some of the constraints on the eligibility of assets for purchase, the ECB has enhanced its ability to do quantitative easing (QE) for longer.
While the market is assuming the ECB may not be as accommodative, we would think it could be just as accommodative and continue to be so for longer than originally anticipated.
We would expect one consequence of this announcement to be much steeper yield curves in Europe, which implies notably higher interest rates on debt of long-term maturities than on short-term. Outside of Europe, Japan’s authorities have also indicated that they are looking for steeper yield curves, so investors may want to consider whether their portfolios are set up for that to emerge as a long-term trend.
It’s also worth noting that ECB President Mario Draghi and his colleagues have demonstrated they are conscious of the potential political risks on the horizon; the ECB statement at its latest meeting explicitly notes that it could increase the buying program again if it deems it necessary.
The Italian Connection
Meanwhile, markets in general seem to have shrugged off the defeat of Italian Prime Minister Matteo Renzi in his country’s constitutional referendum and his subsequent resignation. Unlike other plebiscites this year—namely, the United Kingdom’s European Union (EU) referendum and the US presidential election—the result was largely in line with expectations and any perceived negative sentiment seems largely to have been priced in.
More significant, in our view, will be how the situation in Italy plays out from here. Our view is that an early Italian election is unlikely; we think there needs to be some kind of electoral reform to ensure the electoral process can work appropriately.
Ironically, investors may consider that Renzi’s failure to secure support for his constitutional reforms, which would have weakened the oversight role of the upper house of Italy’s parliament and strengthened the hand of the ruling prime minister, may prove a blessing in limiting the disruptive potential of an incoming administration.
It means no new government could automatically change all the laws or rules within the country without scrutiny from Italy’s upper house. That may offer some degree of reassurance to those concerned about a more extremist government, either from the left or right wings of the political spectrum.
All Eyes on France
So while we’re sceptical about the prospects of imminent elections in Italy, we are very focused on the situation in France, which is due to host its own presidential elections in April and May of next year.
There has been a lot of attention on the prospects of Far Right Front National leader Marine Le Pen winning power in France. She is a committed Euro-sceptic and the question many observers are asking is: If Le Pen were to become the French president, would she be able to call a referendum on France’s continued membership in the eurozone—or even its membership in the EU?
The prospect of an EU without France as a member would be problematic, in our view, so we think many investors are likely to be very focused on opinion polls in France over the coming months, and we’d expect to see French government securities and French assets in general really moving largely in line with what the polls are showing.
The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.
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