A narrow range of political outcomes
As we have commented on multiple occasions in the recent past, we often thought that European credit markets have been hijacked by political risk at the expense of a proper risk assessment of fundamentals, technicals and valuations. With the French Presidential election resulting in the defeat of parties supporting a non-mainstream economic agenda and the likely appointment of a pro-business administration, the range of potential political outcomes in France has narrowed considerably. To oversimplify things, the French political backdrop has moved to an alternative between an actively-implemented economic reform agenda and a light reform agenda from an alternative between staying the euro/EU and moving towards a euro/EU exit. At a time when macro indicators and corporate fundamentals are gaining momentum in Europe and when the divergence in economic performance of the various countries has reduced significantly, we would argue that credit risk in Europe has never been that low since the onset of the GFC about ten years ago.
Political risk still matters for European credit
Notwithstanding the market-positive outcome of the French election and the resulting reduced political risk, we do not believe that political risk itself is completely off the table in Europe going forward. First, because the inherent nature of the EU and the euro makes the region vulnerable to frequent and sometimes unpredictable national elections, which are each driven by different sets of dynamics. Second, because the euro and the current model of market-driven economic integration in the EU are both challenged by significant political forces in some European countries. In France, the new fragmentation of the political landscape may lead to a hung parliament post the upcoming general elections, with some significant influence from euro-skeptic parties on the political agenda. In Italy, the prospect of general elections as early as late 2017 combined with the country’s still sluggish economic performance will raise the risk of an anti-EU government. Even in Germany – less prone to a euro-skeptic political rhetoric – the next general elections in September may create some increase in investor risk aversion towards the end of the summer. Last, the start of the real Brexit negotiation process between the UK and the EU post the British general elections will likely create some uncertainty and unpleasant newsflow. Such process is unlikely to go through without any level of economic and financial stresses for the region although the UK would probably be more vulnerable to it than the rest of the EU if things turn out to be nasty.
Refocusing the market on other risk factors
Going forward, we believe that the reduction of political risk in Europe will help investors to refocus on the region’s improving economic dynamics and to increase their risk appetite for credit, among other asset classes. After years of negative political headlines and crises in the EU, the economy and the euro may well prove to be more resilient than what some market participants have priced in. The bank sector provides an interesting example of this view; although far from complete, the EZ banking union, the ECB and pan-EU regulation have contributed to make European banks more solvent, transparent and liquid than they have ever been. To us, the major risk in the short term lies in stretched valuations, which make many segments of European credit markets vulnerable to sudden changes in investor perceptions and renewed volatility. In the medium term, we believe that the first signs of ECB exit from its current QE programs combined with future rate hikes and balance sheet reduction on the Fed side will create some downside risk for European credit assets, as fixed income yields start rising and financial conditions get tighter.
With the tail risk a Frexit agenda being avoided and the balance of risks being less skewed to the downside now, we have decided to take on more risk on our portfolio – be it from a historically low level. This approach is being implemented progressively by focusing on sectors, names and instruments with relatively low underlying credit risk and avoiding adding IR duration to the Fund. We believe that such strategy is currently the best to enhance the future returns of our portfolio, while limiting downside risk and keeping some dry powder in the event of future market dislocation.