LONDON (Reuters) - In an ironic twist for world markets, the collapse of German government coalition talks has suddenly revived the spectre of European political risk that appeared to have been laid to rest with the election of France’s Emmanuel Macron in May.
It is ironic because Germany’s election in September was widely considered the least likely of several across the continent this year to generate any market volatility or in any way threaten the euro zone project.
So far, markets have followed the 2017 playbook and barely blinked. Flickers of weakness across euro zone markets early on Monday appear to have been snuffed out by the wider backdrop of solid economic growth and corporate earnings, and continued - albeit reduced - stimulus from the European Central Bank.
That may well be how euro markets trade in the weeks and months ahead if the last year is any guide and the economic backdrop continues to trump myriad political uncertainties.
Yet it’s a leftfield risk at the back end of a year that some of the world’s major money managers told Reuters only last week they had virtually removed the substantial euro political risk premia built up over 12 months ago.
Remember, a year ago, European “political risk” was considered one of the biggest threats to financial markets in 2017 with Austria, The Netherlands, France, Germany and potentially Italy all going to the polls.
The fear was a spate of victories for hard right, anti-euro populist parties which would threaten the euro project. A political risk premium was built into euro zone assets like the single currency and peripheral sovereign bonds, and some investors went all in on euro zone breakup trades.
The euro fell 6.5 percent against the dollar in the fourth quarter last year (its worst quarterly performance in nearly two years) and the spread between Italian and German bond yields blew out by 65 basis points between October last year and March this year.
But none of that was on German concerns, and in any case turned out to be short-lived.
After Macron’s victory in France, the drive for deeper euro zone political and economic integration would go up a gear once Angela Merkel was re-elected as German chancellor and Europe’s political figurehead in September.
That risk premium was sucked out of euro zone assets over the course of 2017 as the political risk subsided and the economy went from strength to strength. Bets on euro breakup were crushed, especially after Macron’s rise to power.
“If you would ask me over a year ago today, my biggest surprise would be the Macron election, (it) truly had a meaningful impact on the psyche of Europe,” Larry Fink, CEO and Chairman at BlackRock with assets under management nearing $6 trillion, told Reuters last week.
But it’s not proving to be quite so simple. Even though Merkel probably will be returned as chancellor for a fourth term, it’s not a given after the pro-business Free Democrats (FDP) unexpectedly pulled out of coalition talks after more than four weeks of negotiations.
There is suddenly crisis at the heart of Europe, its strongest economic foundation and guiding political light. Just as investors are preparing to wind down for the year, uncertainty has suddenly sprung from an unlikely source.
The most likely outcomes now appear to be Merkel heading up a minority government, assuming she can cobble together the necessary backing, or the country holds new elections. Either way, she is weakened.
On a national level political paralysis pushes back the prospect of German fiscal stimulus well into next year. It also stalls progress in European economic reform talks in areas such as a common euro zone finance budget, closer banking union and labour market reforms.
From a markets point of view, Merkel and Macron would strengthen the Franco/German axis at just the right time: Europe’s economy is experiencing a “Euroboom”, corporate earnings growth is outstripping U.S. earnings, and the threat of hard right-wing populist election outcomes in France, The Netherlands and Austria all failed to materialize.
All of a sudden, a cloud hangs over the Merkel/Macron partnership. At the margins, the far-right AfD party in Germany will feel emboldened. And a leaderless and rudderless Germany plunges the protracted and prickly EU-UK Brexit negotiations into even deeper uncertainty.
Against that backdrop, investors may consider injecting at least some of that risk premium back into euro zone assets. The euro, euro zone stocks and peripheral debt like Spanish and Italian bonds, which have all performed well this year, could come under pressure between now and the end of December.
In another ironic twist, however, the fall in one of those markets could help cushion any blows in the others and economy at large: the euro.
A cheaper euro boosts euro zone company earnings for overseas investors and so makes euro zone stock markets more attractive. It also makes euro zone exports more competitive on the international stage, boosting the region’s economy and keeping the “Euroboom” going.
That’s the longer economic game. In the short run, it may be a more volatile end to the year for markets than they had bargained for.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; editing by Mark Heinrich