woman newspaper in page

Up until recently, markets have been resilient in the face of a heavy diary of global political events that is set to unfold over the next 12 months. As these events play out, investors face the risk that the standards that economies have enjoyed in recent decades could be undermined by an evolving political landscape that could bring with it rising protectionism, strict immigration policies and even changes to the minimum wage.

Major shifts in government policies create uncertainty that may affect financial asset performance or, at the very least, stoke market volatility. While the focal point at the moment seems very much to be the US elections, Europe’s political risk is abnormally high over the next year.

Dripping with scepticism

All eyes might be on the upcoming US presidential election, but America is not the only country facing political uncertainty. Europe is set to be dominated by political events in the coming year as member states representing more than half of the European Union’s gross domestic product head to the polls. The situation has become more complex given that several countries have seen a rise in right-wing, anti-EU political parties that threaten the status quo. While they might not become ruling parties, they may gain enough popularity or even win enough seats to have an influence on the political debate in much the same way as the UK Independence Party did in the UK.

This makes life more difficult for the EU, an institution based on free movement of capital, goods and labour, and which in our view needs to integrate further and cooperate, or at the very least coordinate more effectively. This anti-EU sentiment also poses a challenge at a time when the European Central Bank is trying to pass the stimulus baton to governments and may make pursuing a much-needed reform agenda more difficult.

Polls and plebiscites

Across the EU, a raft of elections and referenda could change the face of the trade bloc. In Italy, which is burdened by sluggish economic growth, a heavy debt burden and a weak banking sector, December’s proposed referendum on senate reforms is the most immediate test for the EU. Prime Minister Matteo Renzi’s proposed reforms would streamline decision-making and improve government stability. But his promise to resign if the referendum fails has introduced the risk of a snap election ahead of the general election already planned for March 2018. With the Eurosceptic Five Star Movement currently riding high in the polls, an early election could conceivably usher in a new government more inclined to challenge the status quo. Despite being pro-EU, the Five Star Movement is sceptical of the eurozone and is seeking a referendum on the single currency during a time when public support for it is on the wane.

Connect with a relationship manager
Don’t have an RBC relationship manager and wish to find one? Get in touch with one.

In the Netherlands, the spring 2017 elections also pose a challenge, with the anti-EU, anti-Islam Party for Freedom on course to emerge as the largest party in parliament. Though still lacking the support to gain a majority, future governments could either bring the Party for Freedom into office or form a wide coalition with the sole purpose of excluding the party from power. But both scenarios would see governing difficulties and make for an uncertain political environment.

Meanwhile, in France and Germany, we think the prospect of a radical redrawing of the political landscape is less severe, although the rise of populist parties could enable them to influence the political debate. France will hold presidential elections in the spring and then parliamentary elections in June. Far-right Eurosceptic party National Front could see its presidential candidate, Marine Le Pen, progress to the second round, although current polls suggest she is unlikely to win against any moderate counterparts. Despite this, we should not underestimate National Front’s ability to influence mainstream politics and promote its protectionist, anti-European policies in a country where terrorist attacks have become a central issue.

A similar dynamic is being observed in Germany, where the anti-immigration and Eurosceptic party Alternative für Deutschland (AfD) is gaining ground at the expense of the centre. The AfD, which took just 4 percent of votes in the 2013 federal election, now polls more than 10 percent nationally and looks likely to win seats in the autumn 2017 election. However, a government excluding the ruling CDU/CSU (the political alliance of the Christian Democratic Union and the Christian Social Union) seems unlikely at this stage, though the coalition may have to expand should the AfD continue to gain popularity.

Finally, we cannot rule out a third round of Spanish elections by the end of 2016. The Spanish parliament recently rejected a bid by acting Prime Minister Mariano Rajoy to form a centre-right government. Unless this deadlock is solved, the King of Spain will have to dissolve the legislature over the next two months and call a third election.

One of the fastest growing economies in the EU, Spain is the poster child of what reforms can achieve. However, no legislation has been passed in more than a year due to the political impasse. While economies can run without a government for many months, economists worry that the uncertainty could start to dent the recent economic momentum. Opinion polls suggest a potential third round of voting would not bring radical anti-reform forces to power.

A vote for staying the course

Markets were unusually resilient up until recently in the face of rising political risk in the EU, probably courtesy of central banks’ generosity. Despite such support, we would expect a spike in market volatility in the autumn, a period historically associated with meaningful market gyrations.

Remaining invested in well-diversified portfolios during recent periods of volatility has generally helped investors to generate attractive returns. Moreover, we also believe investors should focus on the business not the political cycle. In the US, financial market performance is more connected to the future direction of the economy, corporate earnings and monetary policy than it is to actions that emanate from government. History indicates that the ebb and flow of the business cycle, and recessions specifically, have the greatest influence on investment returns.

Overall, we continue to believe equity markets should be given the benefit of the doubt as long as no US recession or global economic downturn is in sight. Nevertheless, we are aware of rising political risk in Europe and the potential effects that this could have on financial markets.