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Kristina Hooper | April 29, 2019

Elections may bring answers – and more questions – for Europe

It is spring and elections are in the air – along with expectations for increased polarization and uncertainty across Europe.

Pro-EU party wins in Spain – but not convincingly

General elections in Spain were April 28, and the European Union’s (EU) big fear – that Spain would follow in the footsteps of Italy and elect politicians who are antagonistic to the EU – does not seem to have come to fruition, at least not fully.

The current governing party, the Socialists, won the most votes. Therefore, their prime minister will continue to lead the country, and he is very pro-European Union. However, the Socialists (PSOE) and Podemos did not garner enough votes together to win a majority. As with other European countries’ recent elections, we have seen a fall in popularity for mainstream parties and an increase in popularity for a variety of fringe parties, thereby fragmenting votes. Therefore, in my view, PSOE and Podemos will need to form a coalition government with other political parties, and that carries with it some uncertainty.

There are a few possible combinations that could work and enable the Socialists to continue to govern Spain in a coalition government. Some worry that the PSOE may be forced to partner with a separatist Catalan party. This could be problematic, as it would likely mean agreeing to a Catalan independence referendum. If there is difficulty in forming a coalition government, that could result in a widening of spreads for Spanish bonds.

This outcome, while viewed as a win for the EU, is not ideal as the election indicates a growing polarization among the electorate – including a nationalist movement that has been gaining momentum in Spain (the Vox party, which garnered about 10% of the vote1 – although that was below expectations). However, I believe Spain will continue to be pro-EU and that nationalist forces will not gain that much ground. After all, Spain is no Italy. For example, gross domestic product (GDP) growth for Spain is expected to be 2.1% this year, while GDP growth for Italy is expected to be 0.1% this year.2 In addition, government debt-to-GDP in Spain has recently been at 97.1% – which is not ideal but is far more manageable than that of Italy, which was recently at 132.2%.3. While youth unemployment is high in Spain, the general economic landscape is far better than that of Italy. And it is economic dissatisfaction that tends to sow the seeds of strong nationalist and populist movements.

Could the European parliament become Euroskeptic?

European parliamentary elections will occur on May 23. There is widespread fear that the European parliament will experience major changes and greater polarization – in other words, more seats may go to fringe political movements, including those who espouse Euroskeptic nationalist views. Of course, this raises questions as to the efficacy of the European parliament.

In my view, it does seem likely that the two mainstream blocs in the European parliament will lose seats as well as their governing majority. However, it appears likely that they would build an alliance with liberal fringe parties within the European parliament in order to continue to dominate the decision-making on key issues and withstand growing Euroskeptic forces.

This situation is certainly being complicated by questions about whether the UK will participate in the elections. Given how close-at-hand the elections are, it seems likely the UK will participate. However, whether or not it participates is not expected to significantly alter the composition of the next parliament.

And so we should not expect the European Union to become a shrinking violet because of internal schisms. Yes, the European parliament is likely to experience some disruption as a result of growing nationalist and populist forces. However, the EU appears focused on continuing to be an important force in the global scene, and is likely going to move forward with greater regulation – and with a heavier hand with regard to the UK as it nears its Oct 31 Brexit deadline.

In my view, this should not have any material impact on the European economy or markets – except as it relates to the appointment of the successor for European Central Bank President Mario Draghi. As I have said before, that could have a significant impact on markets given how Draghi was able to instill confidence and tamp down systemic stress during his tenure.

Will the UK see another Brexit referendum?

We also have the potential for some kind of election in the UK. There has continued to be a powerful movement afoot attempting to hold a second referendum on Brexit. In addition, while Prime Minister Theresa May was able to survive a “no confidence” vote in December, and therefore is protected from another such vote for the ensuing 12 months, there are reports of machinations going on behind the scenes in an attempt to oust her sooner given the growing dissatisfaction with her leadership.

Amidst all this economic policy uncertainty, one thing seems almost certain, in my view: The longer it lasts, the greater negative impact it may have on business investment, which has already been falling.

India’s elections continue

Important elections are happening outside of Europe as well. For example, we will want to follow the ongoing elections in India closely. Voting takes place over a five-week period, with the outcome to be announced in late May.

Narendra Modi is likely to remain as Prime Minister with his Bharatiya Janata Party (BJP) likely to remain the largest party in Parliament – though it may well lose the outright majority it won in the 2014 general elections (which had been the first in many years). The likely loss of the BJP’s majority would reflect popular disappointment with Modi’s track record in economic policy and performance. Though India is the fastest growing large economy in the world, the growth rate and the labor market have not improved as much as the hype in the 2014 election suggested might happen. In addition, some policies and reforms, no matter how well-intentioned, have had negative effects for ordinary Indians as well as small- and mid-sized businesses because of their design and execution:

  1. Demonetization was a radical and risky measure in November 2016, under which most of the currency in circulation was rendered useless in order to be exchanged and legitimized in a short period. India has the highest proportion of cash transactions and currency in circulation of any large economy because hundreds of millions live on subsistence cash incomes and do not have access or spare resources for bank accounts. The policy had a hard impact on the small-scale sector, farmers and sole trading businessmen. Most of the effects have probably dissipated by now, but there is still a political repercussion.
  2. The Goods and Services Tax (GST) has helped reduce the trade barriers between the states of the Indian Union and should have a significant effect on boosting potential growth, just like trade liberalization between the early U.S. states after the Second Constitutional Convention. However, the GST reform was executed with many levels of tax rates and many exclusions and loopholes, creating complexity and onerous record-keeping requirements that will very likely reduce the potential GDP boost well below the quite optimistic 2% per annum that India’s Finance Minister had projected.

And so, as with the Spanish parliament and the European parliament, I expect a more fragmented Indian parliament with more power for the opposition alliance. That likely means that critical reforms – including labor market liberalization of hire and fire rules, and land acquisition reform to boost investment and efficiency in the industrial and agricultural sectors – could face an even more difficult time. Against that, Modi is likely to continue his reform agenda with the streamlining of India’s bureaucracy, especially if his larger reform agenda is stymied in parliament by stronger opposition parties (given that the bureaucracy is an area where Modi can maneuver without parliamentary backing for legislative reform). In addition, he is also less likely to engage in radical experimental reforms or overrule expert advice as he evidently did with demonetization itself. The net effect of these changes is that the markets may probably remain relatively well-supported and the growth rate may remain in the high single digits where it is now.

What to watch for in the coming week: 

U.S.-China trade talks. U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin will travel to Beijing for trade talks beginning on April 30, with Chinese Vice Premier Liu He once again leading the Beijing delegation. (Liu will then travel to Washington for more discussions starting on May 8.) There is a good chance a deal could be struck in the next few months; however, we need to worry about the potential for it to include a reciprocal enforcement agreement which, as I explained in a previous commentary, could prove very problematic.

Eurozone GDP. We have gotten some disappointing eurozone data recently, so the GDP print will be very important. We will see the first-quarter eurozone GDP figures on April 30.

U.S. employment data. The Employment Cost Index for March will be released April 30. This report is important as labor costs have been on the rise and could be a potential reason for the Federal Reserve (Fed) to be forced to tighten. The Employment Situation Report for April will be released May 3. There was a big surge in jobless claims last week to 230,000, albeit from a 50-year low and albeit during a holiday week.4 However, we will want to carefully analyze this report for any signs of weakness.

Federal Open Market Committee. The FOMC meets April 30-May 1. The results will be helpful to better understand what the Fed is thinking and worrying about – and their certainty on how long they can keep rates on hold.

Chinese manufacturing data. The China Caixin Manufacturing Purchasing Managers’ Index for April will be released this week. I hope that the index will confirm a continuation of improving Chinese data.

Bank of England (BOE). The BOE’s Monetary Policy Meeting is this week, but I believe they are unlikely to make any policy changes at this meeting.

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1 Source: Time, “Socialists Won the Spanish Election, But the Right-Wing Vox Party Gained in Popularity,” April 29, 2019
2 Source: International Monetary Fund World Economic Outlook, April 2019
3 Source: Eurostat, as of Q4 2018
4 Source: US Labor Department, as of April 25, 2019

Important information
Brexit refers to the scheduled exit of the UK from the European Union.
The Federal Open Market Committee (FOMC) is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.
The Caixin/Markit Purchasing Managers’ Index (PMI) for China is considered an indicator of economic health for the Chinese manufacturing sector. It is based on survey responses from senior purchasing executives.
Spread represents the difference between two values, such as yields on two different bonds.
The Employment Cost Index is released by the U.S. Bureau of Labor Statistics and measures compensation costs for civilians, private industry, and state and local government workers.
The Employment Situation Report is released by the U.S. Bureau of Labor Statistics to monitor labor market data on a monthly basis.

The opinions referenced above are those of Kristina Hooper as of April 29, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.