Five Major Political Risks Could Influence the Markets in Second Half of 2017

Written By: Morgan Jones – Corporate Finance

The first half of 2017 was a good “vintage” for equity markets. Wall Street peaked at record levels, with the Nasdaq gaining 15.8 percent and the S&P 500 Index more than 9 percent. After a good first semester, investors have been digesting the good news and wondering about the risks lying in ambush. Here are the five political hot issues that await the markets:

1. Political disappointments in the United States

The expected US rebound in global growth with a synchronized recovery in most regions led markets in the first half. If forecasts remain optimistic for the eurozone, doubt could settle on US growth after a disappointing first quarter. The latest statistics challenge the vitality of US growth, while President Donald Trump’s promises are slow to come true. According to the Federal Reserve Bank of New York, the New York Fed Staff Nowcast, a model projection of growth in gross domestic product (GDP), stands at 1.9 percent for second-quarter 2017 and 1.8 percent for third-quarter 2017. In the absence of fiscal and structural reforms, by the hands of the White House and Congress, US GDP growth could be lower than expected.The truth is that the hope of a huge fiscal stimulus has faded in the United States. Still, confidence indices are improving, as well as buying intentions of companies, while corporates’ results are improving. The American economy is looking more fragile than expected, and the US Federal Reserve Board of Governors will have to take this into account before taking further steps to raise interest rates.

2. Uncertain monetary policies due to lower than expected inflation rates 

The theme of reflation (recovery of economic activity thanks in particular to fiscal stimulus coupled with a rise in prices) was one of the strong points in justifying the increases in the markets during the first half of 2017. But over the last few weeks, expectations of increasing inflation rates have vanished in the United States, as well as in Europe. US consumer prices climbed only by 1.6 percent year-on-year. According to Eurostat, the last published inflation rate in Europe was 1.4 percent. Central banks and markets face the challenge of a return to inflation.

This situation complicates in any case the task of central banks. The US Federal Reserve and the European Central Bank (ECB) may be communicating unclear messages concerning their monetary policies. The European Central Bank’s repurchase program is going on, with some questions about its duration after 2017. The Fed’s decrease of its balance sheet is expected to happen by the end of the year. Markets have a short-term horizon, while central banks are forced to see further ahead. Low inflation rates do not yet mean deflation. Optimism could still go on in the markets.

3. 2017 looks like a new black year for oil: 

• Without any political agreements between oil producers, the fall in the oil price has led to negative ideas for the markets;
• The economic slowdown weighs on the growth of emerging countries but also of the American major industries related to energy;
• The risk of deflation;
• The risk of debt crisis for the most indebted oil companies.

JPMorgan Chase sees an additional risk: a continuous drop of the barrel price to US$40 and even below in the second half of the year could force “the sovereign wealth funds and the managers of the reserves of the exporting countries to become significant sellers of bonds and shares”, in view of reducing their current-account deficits.

For now, the price of a barrel of Brent remains above $45, but investors seem to have lost confidence in the ability of OPEC (Organization of the Petroleum Exporting Countries) and Russia to raise it back to around $60.

4. Political risk remains in the eurozone after the elections in France, with elections in Italy and unclear Brexit negotiations just starting with the UK.

In Italy, the political and economic situation could definitely cause turbulence in the markets. The question of Italian banks, holding billions of unprofitable assets, is not yet settled. There is a strong political willingness to protect Italian investors and savers. But no party has a proposal to resolve the banking problems in Italy. Moreover, the Italian economy is lagging behind in Europe (the International Monetary Fund aims for GDP growth of 0.8 percent in 2018). Concerning the 2018 election forecasts, the most probable scenario is that of a weak centrist coalition government with growth that will not exceed 1 percent in the medium term. The worst scenario for the market is that of a coalition of populists, led by Beppe Grillo, favourable to an exit from the European Union.

5. Geopolitical worldwide risks 

Risks of tension with North Korea and in the Middle East (Syria, Iraq, between Qatar and Saudi Arabia) are diffuse and could bring volatility from time to time. The regional isolation of Qatar could also lead this country to sell certain holdings held abroad, particularly in Europe.

Against those five political risks, trends in mergers and acquisitions could help markets worldwide. They have increased in Europe (Elis-Berendsen, Zodiac-Safran, Eurofins-Genoma, Sopra Steria-Kantor, Amundi-Pioneer) and are boosting the markets. As of May 22, trading volumes reached $207 billion in Europe, twice as much as in 2016, driven by France, the United Kingdom and Italy. There seems to be a discount on the valuation of European markets in US markets. In addition, Brexit, which led to a fall in the pound, also created opportunities, such as Elis’ offer for Berendsen.