Assessing the European risk premium

While the political news-flow calmed down significantly over the summer months, the political agenda for the coming months will provide ample new sources of uncertainty. October is likely to be dominated by the US presidential campaign but uncertainties regarding Europe’s future are likely to re-surface quickly: Spain has to form a government before end-October or call for a third general election in just twelve months, Italian PM Matteo Renzi faces an uncertain outcome of the early-December constitutional referendum and Brexit negotiations have to start in earnest, pending the UK triggering Article 50 of the Lisbon treaty.

All these events matter for the financial markets, due to the relationship between growth and risk premia. Hence markets are particularly vulnerable in the current low-growth period. We expect European political uncertainty to remain high in the coming months, and this could impact business confidence, especially investment decisions. But we have also learnt that market shocks might provide interesting opportunities if central banks apply the financial-crisis template and provide ample liquidity to mitigate the negatives.

In particular, we find that the current risk premium in European equities is largely explained by the level of political risk. We find that there is a correlation between the relative performance of the Eurozone vs. the US and the increase in European political uncertainty. The busy political agenda in the coming months should not allow the European risk premium to decrease durably.

Strategically, we therefore hold a neutral view on euro-zone equities as we are still in need of a new catalyst before we can step up our exposure. Tactically, however, we could still benefit from shorter re-rating periods.

A heavy upcoming political agenda