STATUS QUO OR ANCIEN RÉGIME?

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1 Legg Mason Thought Leadership STATUS QUO OR ANCIEN RÉGIME? Netherlands France Germany When French far-right and anti-euro candidate Marine Le Pen drives more news stories than US and European central bank governors Janet Yellen and Mario Draghi, one can only conclude that political uncertainty is on the up. It has indeed become one of investors main concerns, especially ahead of this year s three national elections in core European countries: the Netherlands, France and Germany. We examine these critical issues: What are the chances of a status quo breakup in the European Union? Are financial markets pricing in the present uncertainty? What can investors do in such scenario? See inside. MAR 217 Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal

2 Since thousands of young Spaniards camped in Madrid in 212 to protest against the establishment, the populism movement has only increased in size and become global. Last year, anti-establishment leaders started to gain crucial votes, mainly the US election and the UK s referendum to leave the European Union (EU). Non-traditional political candidates are becoming more popular, threatening the status quo and making political risk become one of the biggest concerns of investors. This is now especially acute in Europe, which faces three national elections over the next few months in the Netherlands, France and Germany, all EU founding members. The three elections include anti-euro candidates who, if victorious, could seriously challenge the European project and destabilise financial markets. New regime? The rise of populism has been brewing for years, especially since the financial crises destroyed billions of dollars in wealth, left thousands unemployed and governments with piles of debt. Despite central banks efforts to flood the market with monetary stimulus, most developed market governments, especially in Europe, closed the taps and imposed domestic fiscal restrains to keep their deficits in check. Popular discontent increased, and so did income inequality. Voters also were disillusioned with globalisation, one of the forces that had increased corporate profits since the 199s, bringing wealth to some, and leaving others behind. But by the time protestors occupied Wall Street in 211, globalisation was already in retreat: the cost cuts that multinationals enjoyed when producing abroad reached some limits, and some Emerging Markets (EMs) improved their technology and knowledge, narrowing the gap with the richer nations. EM salaries rose in key manufacturing locations, such as China, making production abroad less attractive. Corporate profits stagnated, deepening domestic woes, especially right after the crisis. Once-heralded global public figures, such as the elites schmoozing at the World Economic Forum in Davos, became vilified, while unconventional leaders became more popular for example, US president Donald Trump or French nationalist Le Pen. Britain voted to exit the EU in mid-216 and political uncertainty rose to unprecedented heights. Political risk is now especially prevalent in Europe, especially ahead of the 3 elections. What are the chances of a major disruption in each country? Here s brief guide: Income distribution inequality has increased over the past decade (measured by the Gini coefficient, where represents equal distribution, and 1, perfect inequality) so popular discontent has pushed up political uncertainty indices Global Europe France Germany Netherlands EU US Source: Bloomberg as of 9 March 217. The Gini coefficient measures the extent to which the distribution of income among individuals or households within an economy deviates from a perfectly equal distribution Source: Bloomberg as of 6 March 217. The index used is the Global Economic Policy Uncertainty Index with Current Price Gross Domestic Product Weights, from Baker, Bloom & Davis. Please find definitions in the disclaimer.

3 Netherlands Election date: March 15. Candidates: The Party for Freedom (PVV) is an economically liberal, anti-immigration and anti-european advocate, led by Geert Wilders. It is mostly contended by the People s Party for Freedom and Democracy (VVD), a centre right, economically liberal, pro-european group. The Christian Democratic Appeal (CDA), the Green Left (GL) and the Labour Party (PvDA) are more minor contenders. What are the key issues? Healthcare and pension reform, apart from housing and immigration. What are the polls saying? In early March, the PVV led polls with expectations of 28 seats won at the Tweede Kamer (Parliament), a jump from the 15 it gained in 212. Wilders party is closely followed by the VVD, with 27 expected seats, a sharp drop from its current 41. Expected outcome: Since a majority government can t be formed with anybody short of 45 seats, a coalition government is expected, with as many as four or five parties involved. This is slightly more than usual, given the increased number of populist and single-issue parties. The PVV may not be involved in such a coalition as other parties have expressed reluctance to make an alliance with them, given their more radical, anti-european stance. A VVD-led government is the most expected outcome so, same as now. How has the market reacted? Dutch spreads over benchmark German bunds reached euro-crisis heights, although they have recently abated as polls showed that the expected number of PVV s seats in Parliament had fallen from 36 in early February to 28 in early March. The leading Dutch AEX stock index has gained 4.34% so far this year (as of March 7), more than the STOXX Europe 6 index, up 3.17% over the same period. Dutch spreads: euro-crisis heights Dutch-German 1-year spread 5 4 Basis points JUN 213 JUN 214 JUN 215 JUN 216 Source: Bloomberg as of 7 March 217. The chart shows the difference between German and Dutch sovereign 1-year yields. Please find definitions in the disclaimer. FEB 217 3

4 France Election date: The Presidential election has two rounds, on April 23 and May 7 (if no absolute majority is won in the first round). In June, French citizens will vote again to elect the members of the National Assembly, the country s Parliament. Candidates: The traditional left-wing Socialist (led by Benoit Hamon) and right-wing Republican parties (led by Francois Fillon) are challenged by new incumbents: on the left, former economy minister (under the Socialists) Emmanuel Macron founded his own party, En Marche, although he doesn t position himself as neither left nor right. He is pro-europe and has advocated for a Eurozone finance minister. He also wants to improve France s labour market flexibility. On the right, anti-euro candidate Marine Le Pen has taken her father s Front National group well beyond a minority party. She wants to regain border controls and do a referendum on European Union membership a potential Frexit. This is one of the most contended French elections in a generation, which has also been influenced by scandal: Le Pen s chances increased in February on allegations that right-wing rival Fillon had employed and paid his wife and two children for fake jobs. He is still in the race. What are the key issues? Increasing immigration is a key topic in a country already battered by recent terrorist attacks. What are the polls saying? Macron leads polls with a 54% chance of winning, followed by Le Pen, with 31% (as of March 7). Macron has benefited from the demise of Hamon s Socialist Party, whose chances have fallen partially due to the unpopularity of the incumbent Holland s government. Le Pen s case has slightly fallen, from a peak of 34%, as Macron s popularity increased and his campaign intensified he travelled as far as London to recruit thousands of disillusioned French expats. Expected outcome: Le Pen may emerge victorious in the first round against a divided left, and helped by Fillon s demise and by the refusal of ex-prime minister Alain Juppe to replace him as leader of the Republican party. However, Le Pen may not win a second round, when she would contest a major candidate. In such scenario, polls say that Macron or (before) Fillon, would snatch a victory. How has the market reacted? French sovereign spreads over German bunds have closely matched Le Pen s victory chances, while the country s reference CAC stock index has returned 1.9% so far this year, below the European benchmark. French spreads & Le Pen: together forever? Le Pen s chances of winning France-German spread (RHS) Percent (%) 3 6 basis points Jan-2 Jan-25 Jan-3 Feb-4 Feb-9 Feb-14 Feb-19 Feb-24 Mar-1 Mar-6 Source: Bloomberg as of 7 March 217. RHS is right hand side. The French-German spread shows the difference between French and German sovereign 1 year yields. Please find definitions in the disclaimer. 4 4

5 Germany Election date: Sept. 24. Candidates: The country is still dominated by its traditional right wing CDU/CSU party, led by Angela Merkel, and, on the left, the SPD, led by Martin Schulz (former President of the European Parliament). A recent contender is anti-immigration AfD (Alternative for Germany), which is benefiting from Germany s concerns on immigration. What are the key issues? With the country s economy in good health, immigration is expected to become a key topic in the election, something that could hit Merkel, who led Europe s welcoming of refugees. All political parties are committed to the euro, except the AfD. Germany s swelling Current Account deficit is another topic, less conservative candidates aim for tax cuts and more public spending. A more balanced German Current Account is also wanted by peripheral Europe and the US which run big trade deficits against Germany. What are the polls saying? As of early march, Merkel s CDU/CSU was leading the polls with 33% of the votes, ahead of the SPD s 31%. The AfD came third, with 9%. Expected outcome: Although the election is still quite far, no major change to German politics is expected, with the incumbent Grand multi-party coalition still being favoured by voters. How has the market reacted? Being Europe s engine, both German fixed income and equity markets have performed strongly so far this year. The leading DAX index is up 4.2%, while German 2-year bund yields touched on March 7 an alltime low of a negative 8 basis points. German bunds often attract safe-haven demand in times of global concerns, or on increased European uncertainty. Some investors perceive that were the European Union to break up, German bonds would rally as the country largely helps finance the rest of the area. Bunds are also underpinned by the European Central Bank s asset-buying programme. As if the situation in Europe wasn t enough, political uncertainty is also high in the US, given president Trump s planned tax reform, which could hinder global trade, and in China, which is fighting to reduce mounting leverage and stem a capital flight. German bund yields: crisis, what crisis? German 2-year sovereign yield Percent (%) Source: Bloomberg as of 7 March 217. Please find definitions in the disclaimer. 5

6 What are markets saying? Financial markets, however, are painting a rosier picture, based on a reflation idea that started last year, when China unveiled a monetary stimulus to avoid an economic hard landing. The world s second-largest economy has been able to maintain growth at above 6.5%, annualised, at the same time that a manufacturing crisis in the US has abated. The US central bank says it is ready to continue hiking rates, a sign that the economy is heating up. Finally, Europe and Japan also seem to be waking up after years of dormant growth. Markets are pricing this better outlook: Figure 1: Inflation expectations are increasing, globally 2.5 US Germany Italy Japan Figure 2: The US dollar has stopped rising, indicating less appetite for safe-havens, higher risk tolerance MAR 215 MAR 216 MAR 217 Source: Bloomberg as of 6 March 217. The lines reflect each country s 1-year breakeven rate, or the difference between nominal and inflation-adjusted sovereign yields. Please find definitions in the disclaimer. 11 MAR 215 MAR 216 MAR 217 Source: Bloomberg as of 6 March 217. Please find definitions in the disclaimer. Figure 3: Global spreads are coming down, a sign of lower perceived risk Global High Yield J.P. Morgan CEMBI 1 Global Aggregate (RHS) 3 Figure 4: Volatility is subdued in both equity and fixed income markets Move index VIX (RHS) Move index 5 VIX (RHS) Percent (%) 6 4 Percent (%) MAR 215 MAR 216 MAR 217 Source: Bloomberg as of 6 March 217. CEMBI stands for Corporate Emerging Markets Bond Index. RHS is right hand side. Please find definitions in the disclaimer. MAR 15 MAR 16 MAR 17 Source: Bloomberg as of 6 March 217. The Move and VIX indices measure volatility in fixed income and equity markets, respectively. Please find definitions in the disclaimer. 6

7 So, are markets wrong or is the increase in political uncertainty overstating real risks? Or both? As it is often the case, uncertainty seems the only certainty. But some investors believe that chances of a fast and sharp global growth rebound remain slim: Europe needs to go through three national elections and Britain s departure from the EU; US markets have priced in a successful outcome of policies that still may take more than a year to come into effect; Japan, while improving, is far from full traction, and China is heavily overleveraged. Investors also worry that while the issues that have caused the popular discontent aren t resolved, political uncertainty won t abate. Populist candidates may not emerge victorious in this year s European elections but what about the next round in a few years time? What can investors do? Against this backdrop, picking the right asset class, country, sector or issuer will be crucial for performance. In order to maximise opportunities, investors with a flexible approach will be able to have a bigger selection of assets, without the constrains of traditional benchmark indices. These are normally skewed towards long-only, developed market, highly leveraged issuers, in the case of fixed income, or towards the largest companies, in equities. Investment risks US Treasuries are direct debt obligations issued and backed by the full faith and credit of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance. Outperformance does not imply positive results. Yields represent past performance and there is no guarantee they will continue to be paid. Bond and equity markets are much bigger than that: they also include Emerging Markets, smaller or lower rated companies, bank or infrastructure loans, derivatives, inflation-linked or asset backed securities, all in either developed market or Emerging Market currencies. A flexible manager can also use long or short strategies to profit in both up and down markets. Experience and knowledge has helped active asset managers weather numerous wars and crisis throughout history. 217 appears challenging, but also because of this, full of opportunity. DEFINITIONS Spread product refers to taxable bonds that are not Treasury securities and include securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness. The S&P 5 Index is an unmanaged index of 5 stocks that is generally representative of the performance of larger companies in the U.S. The Federal Reserve Board ( Fed ) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries. The JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad High Yield is the below investment-grade portion of the CEMBI Broad index. The CEMBI tracks total returns of US dollar-denominated debt instruments issued by corporate entities in Emerging Markets countries. The Barclays Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities. The Barclays Global High-Yield Index provides a broad-based measure of the global high-yield fixed income markets. The Global High-Yield Index represents that union of the U.S. High-Yield, Pan-European High-Yield, U.S. Emerging Markets High-Yield, CMBS High-Yield, and Pan-European Emerging Markets High-Yield Indices. 7

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