Equity markets welcome EU election results, but Italy the weakest link

European markets had a quiet start to the week, as the US and the UK are both out on holiday.  However, overall sentiment seems strong as the European Parliament election results have so far not given investors too much to worry about. 

How to figure out the implications of the EU election results 

The key points to note are that extreme anti-EU and far right parties have failed to gain a majority in the parliament, although there have been big wins for Marine Le Pen’s National Rally Party in France, which won more than 23% of the vote vs. a mere 20% for President Macron’s En Marche! Party. The Brexit party in the UK had a strong showing, winning 29 seats, however, remain parties including the Greens and the liberal Democrats have won 36 seats combined, which will hopefully limit the anti-EU excesses of Farage and co. in the Brexit party. 

Germany goes Green for the EU 

Although the two main parties in Germany had their worst showing in a European Parliamentary election since the second World War, German markets have risen on Monday, mostly down to the fact that the Green Party came in at a respectable second place with 20% of the vote, easily surpassing the far right AfD party, who managed to win 11% of the vote. Overall, the Greens and the centre right parties had a strong showing across the region, which could put to bed the uncertainty about the future of the EU and whether more countries would follow the UK and vote to leave the Union. Even in the UK, the strong showing for the Liberal Democrats and the Greens suggest that Brexit sentiment is dying down, and the next UK Prime Minister may be wise to avoid a no-deal Brexit (here’s looking at you Boris!). This is the main reason why losses for the pound have stalled at the start of the week, see below for more pound analysis. 

Italy still on course for a showdown with Brussels 

We mentioned last week that Italy was one to watch in these elections. The Northern League Party consolidated its recent election success by winning more than 34% of Italy’s vote, Silvio Berlusconi also won a seat in the EU Parliament and the far-right extreme Brothers of Italy party picked up more than 6% of the vote. The big win for the Northern League Party sets up a showdown between Rome and Brussels regarding Italy’s budget deficit. The League party has said that it will flaunt the EU’s budgetary rules, which is likely to inflame tensions between Italy and rest of the EU. However, while Italy may be the thorn in the side of the EU during this Parliamentary session, its influence could be neutralised by the large number of other European Liberal MEPs who will now join the EU parliament. Thus, we do not expect Italy’s shift to the right to knock confidence in other European equity markets. 

Why Italy’s FTSE MIB could be under pressure for some time 

Overall, European stocks have managed to eke out gains at the start of the week. France’s Cac 40 shrugged off gains for the far right, likewise, the FTSE 100 did not suffer on the back of big gains for the Brexit party. The notable under performer in Europe was Italy’s FTSE MIB. While a shift away from the centre is a chronic problem for Europe, which has been somewhat ameliorated by the rise in support for the Greens and Liberals, Italy’s problems are more acute. The rise in support for the Northern League Party gives them a mandate to flaunt European rules on Italy’s Budget deficit, which could be damaging for Italy’s bond yields. Thus, we believe that Italy is, once again, the weakest link for the European Union. However, we do not believe that Italy’s emboldened budget stance will lead to a domino effect across Europe. Even Greece, which is on course to hold a general election in the coming months, is likely to vote for an economically stable party, and thus avoid budgetary conflict with Brussels. Italy could be a lone outperformer in the European equity space in the coming weeks. 

What’s next for the pound?

The currency market is worth watching in the coming days. The pound has managed to claw back some gains after a weak performance at the start of the week. It is currently trading around 1.2680, after falling to a low of 1.2660 after the EU election results. There is still some way to go for the pound’s performance to be called a recovery, however, the fact that the Brexit party’s influence has been counterbalanced by a surge in support for the remain parties such as the Green’s and the Liberal Democrats, is a positive for the pound. Although the market may push GBP/USD back towards 1.27, keen FX traders will be looking for a move past 1.2830 – the 38.2% retracement of the 3rdMay high to 23rdMay low – before they become confident in a longer-term recovery for GBP/USD. 

Why the next ECB head holds the key to future euro performance 

EUR/USD has dropped below its 1.12 handle on the back of these election results. However, the long-term outcome for the euro could be determined by a dinner in Brussels on Tuesday night. This is when the decision on who will become the next President of the European Commission will likely be made. If, as expected, the position goes to a French candidate, then the market may start pricing in the prospect of a German at the helm of the ECB, most likely the hawkish Jens Weidmann. If this happens then we may see a sharp reversal in EUR/USD, and a re-pricing of interest rate expectations. Key short-term resistance levels include 1.1215 then 1.1260, the high from 13thMay. 

Economic data to watch 

Aside from the EU election results, it is also worth watching some key economic data releases including Swiss GDP on Tuesday, the Bank of Canada interest rate decision on Wednesday, Japanese CPI on Thursday night, and Chinese non-manufacturing PMI on Friday.