Super Sunday - Mayday Risk 04 May 2012

Posted: 04/05/2012

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French and Greek Elections this Sunday have given the markets lots to fret about. Being at the heart of Europe and one half of the partnership that has driven the European project for over 60 years, attention is likely to focus on France.

Suggestions that France should tear up the Fiscal Compact have made the markets nervous about Hollande, who is favourite to win. A Sarkozy victory would be a market-friendly surprise, but Hollande is unlikely to be the disaster that the markets feared a few months ago. Either way, we feel that policy, with regard to Europe, is unlikely to be significantly different. Parti Socialiste (PS) is fundamentally a pro-European party. Although Hollande will push for more flexibility on the fiscal compact, neither Merkel or Hollande will wish to endanger the Franco-German relationship which enables them to set the agenda for Europe. As for domestic policy, we're unlikely to get the supply-side reforms that France needs under Hollande, but Sarkozy was not making much progress here either.

The Greek election has the potential to be more disruptive. The most likely scenario is a coalition government between the two main parties: the New Democrats, the centre-right party which ran up big understated deficits in the mid to late 2000s, and PASOK, the Socialist party that also managed the accounts so as to be able to join the Euro. These two parties are broadly pro-European and are likely, albeit half-heartedly, to comply with the EU/IMF bail-out programme. However, PASOK looks set to disintegrate and it is not clear the New Democrats (ND) will be able to govern for long, even with the support of what remains of PASOK. ND will need to hold together a coalition or try to improve their position in yet more elections whilst looking to find nearly E12bn in additional budget cuts. This seems like a big ask and suggests even a ND/PASOK win in this weekend's election will not resolve uncertainty about whether Greece will manage to comply with the austerity programme.

The “Independent Greeks”, a new far right party and SYRIZA, “radical left coalition”, on the far left, wish to tear-up the Troika's (EU/IMF/ECB) programme. They are both calling for German World War Two reparations, which they essentially want collateralised in order to obtain new funding. Then there are another 28 smaller parties, the vast majority of which oppose the austerity programme. Disturbingly, a neo-Nazi party called “Golden Dawn” is polling 5%. They wish to expel all immigrants. The threshold for entry into parliament is 3%. If the French first round elections are anything to go by, polls tend to underestimate the votes recorded by the extreme right, so some form of representation is certainly possible. This is not the sort of party that you wish to hold the balance of power, but being so extreme, most other parties are fortunately unlikely to want to work with them.

In our view, it is most likely that Greece will continue to find it very difficult to achieve the targets outlined in the austerity programme. If Greece does fall significantly behind target it would risk jeopardising it altogether, which in turn would pose a considerable dilemma for the Troika in terms of whether to provide further support. Not funding would increase speculation about an imminent Greek exit (without any other financing a new currency might be issued to pay for fiscal outlays). This in turn could lead to a further run on the Greek banking system. A Greek exit would raise speculation about Portugal and Ireland, and even large economies like Spain. Since such speculation has the potential to be self-fulfilling, the Troika may blink before Greece does and soften its stance.

The good news for investors is that these risks are reflected in valuations. A Bloomberg Poll of Global Investors In January showed 59% of investors thought that one or more countries would leave the Euro by 2016. This explains why European equities on criteria such as price to book and price to cyclically-adjusted earnings look cheap versus both history and other markets.

Regardless of the election results this weekend, the economic and policital backdrop will remain difficult for some time. This suggests there is a challenging journey ahead for investors, but also one of opportunities when markets take excessive fright.


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