First it was Brexit. Then the surprise victory of Donald Trump.

If the political surprises of 2016 made one thing clear, it’s that a rising political tide of populism and discontent with mainstream economic thinking are now a global phenomenon. And financial markets have now turned their attention to the Eurozone, where a busy 2017 election calendar has a series of anti-establishment and anti-Euro candidates polling with strong support in their respective countries. Below, we take stock of the major 2017 European elections, their potential consequences for the monetary union, and how they are impacting our asset-allocation decisions.

Elections in the Netherlands (March 15)

Investors will start taking Europe’s political temperature with the general election in the Netherlands on March 15. As we write, Geert Wilders’ Freedom Party (PVV) is ahead in the polls and may take 26 out of 150 seats in the legislature, up from 15 seats in 2012. Gains of this magnitude would be far from sufficient for an absolute majority, though, and the current conservative majority (VVD) has ruled out including Wilders’ anti-establishment party in a coalition government. So, while the next Prime Minister of the Netherlands is unlikely to be Euro-skeptic, strong turnout for the PVV could rouse market fears that anti-establishment sentiment is actually stronger in the Euro area than opinion polls imply. Indeed, we would not be surprised to see such a turnout contribute to further market anxiety around the French election, which is a more meaningful event-risk for Europe.

Elections in France (April 23-May 7)

The 2017 presidential election in France is the largest source of European political risk for two reasons. First, the far-right National Front candidate Marine Le Pen is leading in some polls for the first round of voting scheduled to take place on April 23, and her supporters report that they are considerably more committed to her candidacy than her opponents. Second, the core of Le Pen’s anti-Euro and anti-immigrant nationalist political agenda is a truly existential threat for the Euro, as the Franco-German alliance has formed the core of the European political and monetary union since its inception. As popular support would likely consolidate behind a more centrist candidate (which polls suggest is Emmanuel Macron, an independent), Le Pen is widely expected to lose in a second-round runoff (Exhibit 1). However, the likelihood of her even reaching a second round of voting has put fears of another populist surprise back on the table, with the existential risk of a Euro breakup.

Exhibit 1

Despite the Odds for Le Pen, Still Fears of Another Populist Surprise -- OppenheimerFunds

Elections in Germany (September 24)

Not all European elections this year hold downside risks. When German voters head to the polls in September, an upset for Angela Merkel could actually allow rival Social Democrat Martin Schulz to advance policies that would foster greater European integration. Schulz was one of the authors of the 2015 “Five Presidents Report,” a roadmap for political and economic integration of the European monetary union in the next decade. Reforms focused on deepening the banking union, launching a capital-markets union and enhancing fiscal policy coordination are all tenets of a strategy that would resonate positively with financial markets. In addition, Schulz’s Social Democratic Party of Germany (SPD) has shown willingness to allow more fiscal flexibility in return for reform in the European periphery. In other words, Germany is not at risk for a potentially damaging political upheaval at this stage.

Italy: No Elections, Yet

Italy is not part of the 2017 election calendar, at least not at this stage. After the popular rejection of the constitutional referendum last December, Italy is currently working under a transitional government that should stay in power until the next scheduled elections in 2018. However, the political landscape remains highly unstable, as the left wing of former prime minister Matteo Renzi’s party (PD) works to form a separate political entity known as DP. It is still unclear how much popular support will be lost by the PD due to such a rupture. While preliminary estimates suggest minimal impact, the anti-establishment and anti-Euro Five Star Movement is still polling as a major political force in Italy and represents a threat to European stability.

Political Risk and Portfolio Positioning

We are often asked how to manage political risk in a portfolio, or about the role elections play in our investment process.

In our opinion, political risk matters — but cyclical dynamics remain the primary driver of financial markets in the medium term. So what is our view on the macroeconomic environment? As outlined in our 2017 Outlook, our proprietary leading indicators continue to suggest the global economy is in an “expansion” regime, experiencing a broad-based and synchronized acceleration in growth momentum. This positive momentum has been in place for the past six months or so, and we expect it to continue in the near term (Exhibit 2).

Exhibit 2

Positive Global Macro Momentum -- OppenheimerFunds

Europe is no exception, where the growth outlook is improving in both the core and the periphery. Further, monetary policy remains accommodative and, while fiscal policy is not yet expansionary, the negative impact of austerity ended more than a year ago. As outlined in our macro regimes framework, the “expansion” regime is typically supportive of risk assets — particularly global equities — and we are positioned accordingly (see our latest GMAG monthly blog).

However, political risk in Europe has led us to assume a smaller overweight position in European equities than we would have otherwise. In other words, political uncertainty at this stage is informing the sizing of our view but not the view itself. What do we mean by that?

Typically, a backdrop of positive global growth is conducive to European equity outperformance — not only on an absolute basis, but also on a relative basis — versus other developed markets, such as the United States, the UK or Japan. In particular, given their larger concentration in cyclical sectors, high exposure to global trade and higher leverage ratios, European equities have historically performed like a “high beta” version of global equities. Simply put, if global growth is accelerating, European equities tend to outperform. Therefore, today’s economic environment alone would lead us to an overweight position in global equities coupled with a relative overweight in Europe, versus other developed markets.

However, given the noteworthy election risks this year, we believe economic policy uncertainty is likely to impose some drag on European assets relative to “normal” times. To some extent, we believe this effect has already been happening over the last six months as returns on European equities (i.e., high beta) have only matched U.S. equities (i.e., low beta) in local currency terms, instead of outperforming as their more cyclical nature would have suggested.1 This “election risk discount” is confirmed by the widening of French and Italian sovereign spreads, which indicates increasing market focus on political risk (Exhibit 3).

Exhibit 3

Widening in French & Italian Sovereign Spreads Indicates Election Risk Discount -- OppenheimerFunds

Therefore, while we continue to overweight global equities versus government bonds, we favor a broadly diversified equity exposure, without a geographic preference toward Europe.

Summary: Our Asset Allocation Strategy on the Eve of European Elections

In closing, we believe European election risks have to be taken seriously, but the supportive macroeconomic environment is a more important driver of equity markets at this stage. Our investment process leads us to be overweight global equities versus government bonds, while factoring in political risks in sizing our European equity exposure. In addition, we are underweight European government bonds and the Euro versus our benchmark. Finally, our dynamic asset allocation process will continue to adjust to evolving economic and political developments.

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1 Based on MSCI U.S. and EMU Total Return Indices.