“Business as usual” the least likely outcome for Europe
on February 9, 2017

EU Feb17

Europe is heading in to the Great Unknown, as Monday’s post highlighted.  The UK, The Netherlands and France are not the only political uncertainties that we face.  Elections are also due in Italy and in Germany.

   Italian elections. After premier Renzi’s referendum defeat last year, it seems like that Italy will hold elections this year, probably in the next few months. A the moment, the most likely winner is former comedian Beppe Grillo.  As I have discussed before, his main policy is for a referendum to exit the euro, but stay in the EU.  But, of course, it is also possible that the current Gentiloni government might survive until the scheduled election date in 2018.

If Grillo wins, the entire European banking system is likely to go bankrupt, as well as the European Central Bank (ECB).  The reason is that leaving the euro, and returning to the lira, would inevitably lead to a major devaluation of at least 20%.  As the ECB is the main owner of  Italian government debt, thanks to its Quantitative Easing programme, it also would go bankrupt.  As Astellon Capital note, the critical legal issue is that the Bank of Italy is privately owned by the Italian banks – not state owned.  The ECB claims the government would still be responsible for the debt, but investors and other governments are unlikely to wait around for Italy’s slow-moving courts to reach a decision.

   German elections. In October we then have the German elections, where Angela Merkel is seeking a fourth term.  Her credibility has been badly damaged by her handling of the refugee crisis, although most polls suggest she is still the favourite.  Germany also has a growing challenge from an anti-EU party, the Alternative für Deutschland (AfD).  But her main opponent is the new pro-EU leader of the Social Democratic Party (SDP), Martin Schulz.

A win for Merkel would obviously be “business as usual”.  But if Schulz wins, he would bring a new dimension to the political debates over the future of the EU, as he was the President of the European Parliament until he resigned to seek the leadership of the SDP. Whereas Merkel saw herself as a “safe pair of hands”, Schulz is likely to be a more activist Chancellor, if elected. His reputation at the Parliament was of “someone who got things done”.  But his actual policy objectives are unclear at the moment.

COMPANIES AND INVESTORS NEED TO PREPARE FOR VERY DIFFERENT OUTCOMES
Voters have got tired of waiting for change to take place.  As I noted in November, 69% of Germans, 82% of Italians and 89% of French feel their country is going in the wrong direction.  So they are prepared to try different options, just to see what might happen.  In turn, this means that Europe, and the world, is entering a Great Unknown.  At least 4 quite different alternatives could therefore result from this year’s elections:

  Business as Usual.  Perhaps Rutte, Fillon and Merkel will win their elections, Gentiloni survive into 2018, and May get her Brexit deal.  But this seems just a 10% probability today
  A triumph for the Populists. Populist success could continue, with Wilders winning in The Netherlands, Le Pen in France and Grillo in Italy, whilst the AfD wins a strong position in Germany.  This is a 25% probability
  Smörgåsbord. Each country might go its own way, with Wilders winning in The Netherlands, Macron winnng in France, Gentiloni surviving into 2018 in Italy, and Merkel winning in Germany.  This is also a 25% probability today
  A New Broom.  Wilders wins in The Netherlands and Grillo in Italy, whilst Macron and Schulz win in France and Germany.  This is perhaps the most likely outcome, but has only a 40% probability

Each of these outcomes would have radically different implications for companies, investors and us as individuals. The Populist, Smörgåsbord and New Broom outcomes would also give very different outcomes for the Brexit process. It could easily become of only marginal importance for EU leaders, if “business as usual” options disappear.  In turn, this would make May’s position back in the UK, very difficult indeed.

Nor can one ignore the potential impact of events, such as a Greek default, or of further interventions by Presidents Trump and Putin.  Both would be happy to see the EU disappear. These widely differing alternatives highlight the dangers of continuing with a one-dimensional view of the world based on economics.  Political risk has returned, and is likely to continue rising up the agenda for a long time.

We are entering the Great Unknown in Europe over the next 9 months.  Everyone will have their own views of the probabilities.  But the crucial point is that every country in the world is likely to feel the impact, in some way, if “business as usual” fails to occur.  And it will then be too late, at the end of the year, to suddenly wake up to the implications for your business, and for you personally.

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