Political risk has returned to the eurozone and is worrying the markets. Jean-François Gillardin, Head of Discretionary Portfolio Management at Banque de Luxembourg offers some explanations.

The Italian government's policies have fuelled fears of fiscal slippage and impacted the country’s assets on the markets. President Mattarella’s refusal to approve the government will probably lead to fresh elections. After a particularly calm year in 2017, volatility came back with a vengeance in 2018. Several factors have caused this new bout of instability on the markets.

The first explanation is the return of political risk in Europe, in the wake of the Italian election results. Together, the eurosceptic Five Star Movement and the far-right League won around half the votes in the Italian elections. These two parties were even preparing to form a government to stimulate internal demand by increasing the public deficit. Their programme’s flagship measures ranged from slashing taxes to establishing a universal basic income, while also proposing to reduce the retirement age and cancel a planned VAT increase. However, President Mattarella's opposition to the appointment of a eurosceptic to head the Finance Ministry has blocked the programme and is likely to lead to early elections.

Fears of budgetary slippage, coupled with a potential strengthening of the anti-establishment parties if new elections take place, have driven Italian bond yields sharply higher. The 10-year yield rose from 1.8% to over 3% in May, dragging Spain and Portugal along in its wake. The market sometimes has a tendency to forget this, but the periphery countries – apart from Ireland – are more indebted now than they were in 2011 at the time of the sovereign debt crisis. According to IMF figures, Italy’s debt has increased from 117% of GDP in 2011 to 130% today, Spain’s from 100% to 110%, and Portugal’s from 111% to 121%.

Without support from the ECB, the recent tensions on these countries’ yields could increase. The cessation of the asset purchase programme in September – which appeared to be a certainty just a few weeks ago – could now be called in question.

Lack of visibility on Donald Trump’s policies is also upsetting the markets at regular intervals. Trump is, of course, a master in the art of the effect of making announcements. The same technique is used each time: he starts with an aggressive tone then gradually gives a little leeway for negotiation, and eventually ends in a compromise. This is how he operated when he wanted to impose taxes on steel and aluminium imports, and in trade negotiations with China. Ultimately, common sense prevailed in each case in the end and the decisions taken were some way from the US President’s initial demands.

Slowing growth

The growth slowdown is another source of concern for the markets. The latest economic data are showing signs of flagging, particularly in developed countries: although recent statistics have continued on a favourable path in the US, they came out below expectations in Europe and Japan. In emerging markets, despite a recent spell of weakness, macroeconomic data were more or less in line with expectations.

Leading economic indicators like the PMI (Purchasing Managers’ Index), reflect a similar pattern, showing slight signs of a slowdown, both in developed and emerging markets. Overall, the economic environment is generally buoyant although growth has probably peaked.

Given the weakness of bond yields, we continue to favour high-quality equities in our portfolios. We particularly like low-leveraged companies that are able to generate regular cash flow and offer a high return on equity. Provided the macroeconomic environment remains positive, we will view any bouts of weakness on the markets as an opportunity to top up our exposure to equities.