All eyes were on Europe this past week. First, U.K. Prime Minister Theresa May announced her resignation. Then the European parliamentary elections took place. Here are the key takeaways from a momentous week for the European continent.
As May exits, anything could happen with Brexit
After having her original Brexit proposal rejected multiple times, May offered another Brexit plan last week, which included the possibility of a second referendum. This was met with significant displeasure by her own party, the Conservatives, and she once again came under pressure to resign – but this time she capitulated. May announced that she will resign as Conservative Party leader on June 7, which will then result in the party choosing a new leader. She will continue to serve as prime minister while the process to choose her replacement unfolds.
The most likely successor is Boris Johnson, a pro-Brexit hardliner. Given this development, the odds of a “no-deal” Brexit have increased, given that Parliament is unlikely to support any Brexit plan coming from Johnson, just as it did not support the proposal from May. Having said that, anything is possible: we could see a new general election, a new referendum, or the U.K. crashing out of the European Union (EU) come Oct. 31. For example, we can’t underestimate Jeremy Corbyn’s desire to regain support for the Labour Party that was lost by not continuing to back remaining in the EU. He has already pledged his support for a second referendum, and I believe it will gain momentum as more rational legislators find it a more appealing alternative than a no-deal Brexit. In the near term, I expect volatility for the pound, U.K. equities and gilt as markets deal with this uncertainty.
Pro-EU parties hold on to their parliamentary majority
As expected, there was fragmentation in the voting for the European Parliament, with more extreme parties on both sides winning more votes. However, the outcome was not as negative for the EU as was expected, with Euroskeptic parties winning fewer seats than projected. And because pro-EU parties have continued to hold the majority in the European Parliament, EU economic policies should be unaffected, in my view.
- In the U.K., Nigel Farage’s Brexit Party received more votes than any other single U.K. party. But counted together, the parties that support remaining in the European Union slightly outnumber those supporting Brexit. This suggests that if a second referendum were held now, it would be a tight contest, but the option to remain in the EU would likely win. This could embolden the U.K. Parliament to take the reins of the Brexit process.
- In France, Marine LePen’s far-right party garnered more votes than President Emmanuel Macron’s party. However, it is unlikely to impact his leadership of France – or his stature in the EU. In fact, Macron has been benefiting from his de facto leadership of the Alliance of Liberals and Democrats for Europe (ALDE), a conglomeration of pro-EU parties that has gained support in these elections. He has been flexing his muscles in the horse trading with other European countries over whose picks will hold the seats of power in the next European Commission (EC). Macron has been attempting to block Germany’s choice to be EC president, and I am following this closely because of the implications for the European Central Bank (ECB) president. If Macron were to win this struggle over the EC president, then the consolation prize for Germany could be the ECB, which could be very problematic given that the likely “German candidate” for ECB president is Jens Weidmann, a monetary hawk who could significantly alter monetary policy in the region and undermine confidence.
- In Italy, the popularity of Matteo Salvini’s League Party may encourage him to end his troubled coalition with the Five Star Movement political party, which got far less support in the elections. Some are suggesting the League may form a government with Silvio Berlusconi’s Forza Italia or another party. However, I think Salvini may prefer the dysfunction of the Five Star Movement, which enables him to maintain the upper hand. And so I expect him to stick with them – at least until budget talks move into high gear this autumn. I also expect a heightening of tensions in the budget talks, no matter which party is in the governing coalition with Salvini, given Italy’s high debt load and relatively low economic growth. It will likely be a repeat of last year: After a lot of squabbling, Italy may get a slap on the wrist by the EU and continue with business as usual.
- In Greece, the parliamentary elections delivered a victory of sorts for the European Union. The current governing party, the Syriza party, performed poorly while the New Democracy party, which is more business-friendly and pro-EU than Syriza, performed much better. Following these results, Greek national elections have been called and are likely to happen within weeks, creating short-term uncertainty.
- In Germany, the Christian Democratic Party was punished by voters, while the Green Party picked up votes. This waning political support suggests Chancellor Angela Merkel may become more vulnerable and less effective. This could be problematic, especially given signs the German economy is slowing.
Recapping recent events in the U.S.
While the European elections offered some positives, we can’t ignore recent events in the U.S. that are more concerning:
- Last week saw a total breakdown in trade talks between the U.S. and China, with no plans for any talks in the future, capped by the creation of a trade war fight song in China (the lyrics to the chorus are, “Trade war! Trade war! Not afraid of the outrageous challenge! Not afraid of the outrageous challenge! A trade war is happening over the Pacific Ocean!).1 In my view, we must assume as the base case that there will be a long, cold trade war – and with it is likely to come a deterioration in economic growth, particularly for the U.S. and China.
- The IHS Markit flash Purchasing Managers’ Index (PMI) for the U.S. for May fell to a three-year low, and new business and future expectations sub-indexes showed deterioration.2 I believe this is reflecting the negative impact of the U.S.-Sino trade wars. We will want to follow this closely, as the IHS Markit PMI tends to be a relatively accurate leading indicator.
- S. Treasury Secretary Steve Mnuchin warned that there could be a default in late summer if the debt ceiling is not raised. Mnuchin and other administration officials are beginning negotiations with congressional leaders on a two-year budget deal that would also increase the nation’s debt ceiling, combining the two issues of spending caps and the debt limit. I worry that these negotiations will become polarized as Congress and President Donald Trump look to the 2020 election and behave like they are on the campaign trail. This could have negative consequences, as ratings agencies Moody’s and Fitch have warned that they could downgrade the U.S.’ credit rating.
- Federal Reserve Chair Jay Powell gave a speech last week in which he cautioned against the rising level of corporate debt. According to Powell, “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect.”3 However, he insisted that we are not at the point of alarm, noting that “…the parallels to the mortgage boom that led to the global financial crisis are not fully convincing”3 and that “the financial system today appears strong enough to handle the potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages.”3 His cautionary words are a reminder that, in general, we need to be concerned about the rising debt levels that governments, households and corporations are taking on.
Greater possibilities together
On a final note, last week was a momentous one for Invesco as well, as we completed our acquisition of OppenheimerFunds. I anticipate that some OppenheimerFunds clients may be reading my blog for the first time today. I’m excited to welcome you to Invesco, and I look forward to sharing my weekly column with you as we navigate this exciting, volatile market landscape in pursuit of greater possibilities together.