Trading the EU elections, a guide
Europe heads to the polls on Thursday 23rdMay, with the conclusion of voting on 26thMay. In total 751 members of the European Parliament will be elected in the coming days. Unusually, EU elections do not have big ramifications for financial markets; however, the political backdrop is particularly incendiary in 2019: one country (Italy) is fighting the bloc, while another (the UK) is trying to leave it. A lot of the focus in the build-up to these elections has been on Brexit, however, as we try to explain, the Brexit issue is one of many that could arise from the EU elections this week and disrupt financial markets in the short to medium term.
Brexit is not the only issue
Key market-moving outcomes from this election do not only hinge on a surge in support for populist candidates, this election will also determine who the next President of the EU Commission will be, as incumbent Jean-Claude Juncker will not stand for a second term. The knock-on effect of this decision may impact the election of the next ECB President, which may have a large impact on the euro. The future of Angela Merkel hangs in the balance, and Italy’s fragile coalition could also falter as a result of these elections. Both of these events have the potential to move sovereign bond yields, which tend to have an inverse correlation with the performance of the euro.
Minerva Analysis’ EU elections watch list
Below, we list the key points to look out for from this election, as well as other factors that could influence European asset prices in the coming days.
· Italy:The Northern League Party, part of Italy’s ruling coalition, has started to kick up a stink about the EU’s fiscal rules, a key piece of the fabric of EU life. It wants to flaunt these rules in its upcoming Budget, to expand Italy’s deficit and make good on its public spending pledges. The Northern League Party is expected to increase its number of MEPs from 6 to 27, which could give Deputy PM Matteo Salvini a mandate to pursue a hard-line on Italy’s Budget deficit, which may lead to the collapse of the ruling coalition. If Salvini comes out of this election as a major foe of Brussels’, then we could see a persistent widening of Italian bond yields vs. their German counterparts and Italian banking stocks could also take a knock. Historically, upward pressure on Italian bond yields can also trigger a wave of downward pressure on the euro. For example, as the spread between Italian and German bond yields has widened to its largest level in a year, it has coincided with a near 2-year low in EUR/USD. Thus, the Northern League’s performance in these elections could determine the short-term direction of the single currency.
· Populism across Europe:Overall, populist politicians are expected to win approx. 180 of the 751 seats in the European Parliament. This falls short of a majority. Aside from Italy where populism is on the rise, if there are any signs that populism is peaking, particularly in Germany, then this may be euro positive, especially against safe havens including the yen and the Swiss franc. For the euro to rally on the back of this election result, we believe that a relatively large drop in support for populist candidates, particularly in Germany and Austria, is necessary to balance out any rise in support for Italy’s Northern League.
· Germany: There is increasing pressure on Angela Merkel to resign in the aftermath of these elections, particularly if her Christian Democrat party loses ground in the European Parliament this week. Merkel’s successor, Annegret Kramp- Karrenbauer, has called a party conference for June 2nd, which is seen as a move to force Merkel’s hand. If it looks like pressure on Merkel to resign is growing, then the euro could wobble. Of course, Merkel, who has planned to remain in power until 2021, could outmanoeuvre her successor, and resist attempts to resign. If this occurs, then euro downside may be limited, as the last thing Europe needs after an election is a major reshuffle of key European leaders.
· Brexit: The deepening political uncertainty has taken its toll on the pound this week. GBP/USD is at its lowest level since January as fears about a whitewash for the Tory party in the European elections fuel trader anxiety about a no-deal Brexit. The expected strong show of support for the Brexit party may topple Theresa May as prime minister before the end of the week, which could then make way for an arch Brexiteer to take the top spot in the British government. Since Brexit has been kryptonite for the pound over the last 2 years, anything but a shock in the EU elections, for example a strong show of support for the Liberal Democrats and Change UK, two pro-remain parties, is likely to weigh further on the pound. With the selling pressure on GBP/USD unremitting, the lows from December, just below $1.25, are now in view.
· EU President:As we mention above, this election will also help to determine who will be the next EU President. If the Presidency does not go to a German, then the chances of the ECB presidency going to a German candidate are likely to increase. Thus, the market may start to price in the prospect of the head of the Bundesbank, Jens Weidmann, taking the helm at the ECB. He is a controversial figure who is renowned for being hawkish, if the market believes that he is the hot favourite to take the top job at the ECB then expect the prospect of a late 2019 rate hike from the ECB to rise, which may boost the euro. After falling to a 2-year low at $1.1150, a hawkish ECB President could be the best chance for a recovery in EURUSD, with a return to $1.14 a major level of resistance on the single currency’s road to recovery.
As we move to the end of the week, the EU elections are likely to be the main focus for investors. However, a sense of unease is pervading global financial markets and risky assets are under pressure. Not even dovish Fed minutes could reverse Wall Street’s decline on Wednesday, suggesting that caution is the order of the day as the US-China trade spat spills into the tech and communications sectors. Although the actual declines for US indices in recent weeks have been fairly small, the S&P 500 is 3% lower since its April peak, the risk is to the downside, especially for US firms with large exposure to China, think Apple, Caterpillar, Boeing and luxury goods companies, is on the rise.