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The Stock Market Sees Nothing to Worry About—That May Be About to Change

Key Points
  • Europe's economy is performing the best in many years on many key measures.

  • Stock markets are currently behaving as if there is nothing to worry about, but that may be about to change now that we are within 45 trading days of the French Presidential election.

  • Savvy investors should be prepared for a rise in volatility in global stock markets in the coming months.

The Eurozone economy may be in the best shape since the financial crisis:

  • The January reading for the Eurozone Composite Purchasing Managers Index indicates that the Eurozone economy may be growing at its fastest pace in almost six years.
  • The number of people employed in the Eurozone rose by nearly 3 million in the past year, returning employment to the all-time high seen in 2008.
  • Loans to businesses have been rising at the fastest pace in seven and a half years, joining the rising index of leading economic indicators as a positive sign of future growth.

So what’s the problem?

Elections in the Netherlands, France, Germany and perhaps Italy are on 2017's calendar with potentially negative outcomes for investors. While markets are currently behaving as if there is nothing to worry about, evidenced by the market-based measure of future volatility in Europe’s stock market near decade lows, this may be about to change.

Europe's markets expecting lowest stock volatility in a decade

Source: Charles Schwab, Bloomberg data as of 2/17/2017.

While polls favor establishment candidates in the French elections (a first round on April 23 and likely run-off between the two leading candidates on May 7) and German elections in the fall, polls proved unreliable in 2016. A win by France’s Marine Le Pen in the Presidential election could lead to a crisis as she seeks to take France out of the euro and redenominate the country’s debt in francs, resulting in devaluation, default, and a huge shock to the financial system.

What do the next 45 days look like?

The critical period 45 days before the first round of the France’s Presidential election started on Friday. This timeframe is when stocks began to slide 5-10% ahead of 2016's key votes, as you can see in the chart below. Stocks rallied following the votes in 2016 as the outcomes became known and the uncertainty faded.

Stocks slide ahead of key votes

Source: Charles Schwab, Bloomberg data as of 2/17/2017.

What's the risk?

Le Pen's party, the National Front, has a passionate, but narrow base of support. This passion may result in the party taking the lead in the crowded first round of voting on April 23, but the limited support is likely to cause it to lag in the run-off between the top two candidates on May 7. The polls show Le Pen with a 20-point deficit in the second round versus establishment candidates. But polls, even when the gap is as wide as 20 points, are hard to count on after 2016’s surprise outcomes.

Instead, it may be useful to look back at the regional elections of 2015, when the National Front led the first round voting in six of the 12 mainland regions but failed to win any of them in the run-offs. Voters from other parties did not shift their support to the National Front, effectively keeping the party out. This illustrates that the pro-European candidate in the run-off (Emmanuel Macron or Francois Fillon) would probably receive the endorsements of the parties that drop out of the first round instead of Le Pen.

It’s important to keep in mind that for a potential crisis to develop not only would Le Pen have to win the Presidency, the parliamentary elections in June would also have to strongly favor the National Front (which currently only holds two seats in France’s 348-seat Senate) to have any hope of enacting her proposals. She would also have to successfully return France to the franc from the euro and to leave the EU—something the French people do not seem to want, according to recent polls (only 33% favor leaving as of December 2016).

Despite all these challenges, markets may begin to price in some uncertainty given the low probability, but potentially negative market outcome, of a "Frexit."

What about the other elections?

France isn’t the only European election of 2017, but others pose less risk to investors.

  • The Netherlands election is on March 15. The Party for Freedom, an anti-European Union (EU) party, is expected to win the largest share of seats in parliament. However, other parties have already stated they will not form a coalition with the Party for Freedom. That makes it unlikely to be able to form a government to advance its agenda, posing little risk to investors.
  • The German election will be held on September 24th. While anti-EU parties have gained support, with her approval ratings at a strong 74% as of January 30, 2017, it remains likely that Angela Merkel will win a fourth term as chancellor. While a status quo outcome may not pose a risk to investors, it is worthwhile to note that populist parties are pulling significant support from establishment parties. This erosion of the political center may mean Merkel’s influence and political capital will be less than in previous years as challenges from Europe’s vulnerable banking systems to its controversial immigration policies mount.
  • While it could be delayed until 2018, Italy may hold an election in the second half of 2017, if it appears likely former Prime Minister Matteo Renzi's Democratic Party would win. While anything can happen, the most likely scenario of a win by the Democratic Party is of limited risk to investors.

What might happen?

Solid economic growth may help insulate Europe's stocks from political wrangling, but it doesn't make them immune. The stock market in Europe, and perhaps elsewhere if 2016 is a guide, may slide during the coming months. While markets reveal complacency among participants, savvy investors should be prepared for a rise in volatility in global stock markets in the near future.

Next Steps

Fed and Bank of Japan Meetings: What to Watch
Changes at the Fed: What Does the Coming Personnel Shake-Up Mean?
The Endowment Effect: Do You Overvalue Your Investments?

Important Disclosures

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