Euro bull case challenged by political risks and slowing growth


  • Euro has strengthened based on improving growth and falling political risks
  • Both of these factors are at risk today: significant upcoming political risks this week
  • Outlook for economic growth worsening as Eurozone business sentiment heads south

Following French presidential elections last year, the bullish case for the euro was largely driven by accelerating economic growth and falling political risks. While we’ve been bullish on the euro for quite some time, upcoming political events and slowing growth expectations are putting a dampener on the rally. This coming Sunday, the outcome from Italian elections as well as an SPD vote (in Germany) on another “grand coalition” deal with Angela Merkel’s CDU/CSU will be announced. Looking at Italy, the Eurosceptic “Five Star Movement” (Movimento 5 Stelle) is currently leading the polls. Turning to German politics, polls indicate that only a slim majority of SPD delegates view another coalition deal in a positive light. Finally, forward-looking economic indicators (such as Eurozone manufacturing PMIs and the German IFO expectations) have deteriorated this year. With politics and economic growth weighing on the future outlook, going long euros is less compelling today.


Italian elections a meaningful risk

The biggest threat to the status quo is the possible victory of M5S, a Eurosceptic party pushing for a greater degree of direct democracy and limits on immigration. Looking at M5S’s agenda, leader Beppe Grillo had previously called for a national referendum on Italy leaving the euro area, but has since moved away from this position. While the party is currently leading in the polls (27% - 29.4%), it is unlikely to form a majority government without coalition partners. The center-right coalition is currently polling between 34.7% and 38.6%, while the center-left coalition is polling between 26% and 29.3% according to Reuters Italy. Given recent constitutional reforms, no party is likely to form a majority without forming a coalition based on latest polling figures. The election results on May 4 are thus unlikely to be conclusive. As a result, many investors are confident that Italian elections pose a limited threat to the unity of the Eurozone.

While this may be true, the possibility of M5S joining the next Italian government is a real risk for the common currency. At the EU-level, an M5S-led government is less likely to follow the Franco-German agenda of deeper EU integration. Domestically, a Eurosceptic government is also likely to resist institutional reforms pushed by Brussels. Instead, there is a risk that the next government could attempt to jumpstart growth by pursuing fiscal stimulus at the cost of more government debt. If M5S performs better than current predictions, expect the euro to weaken as a result.


SPD vote the bigger threat

An even bigger risk for the euro is likely to come from an upcoming SPD vote on another grand coalition deal. According to Bayerischer Rundfunk (a public media company based in Munich), 463,723 members of the SPD will vote on the agreement. Based on the latest polls conducted by ARD-Deutschlandtrend, 51 percent of SPD members view another grand coalition as “very good” or “good”. 49 percent viewed another coalition as “not so good” or “bad”. While 76% of delegates were in favor of a grand coalition deal back in 2013, a much closer result is expected this time. Given the recent surge in SPD membership from far-left socialists, there is a significant risk that the party rejects the deal altogether.

If the SPD fails to approve the deal, the German President will nominate a candidate to serve as chancellor. The next chancellor will then be selected by a vote at the Bundestag (Germany’s parliament). Merkel has already made it clear that she will be available to serve as the next Chancellor as part of a minority government. This scenario would be a clear negative for the common currency, as institutional reforms in the EU are less likely without strong leadership from the bloc’s biggest economy. Without a majority, Merkel will need to build support from delegates in the Bundestag for each new law on an ad hoc basis.


Forward-looking economic indicators starting to disappoint

Finally, forward-looking economic indicators are also worsening. Recent sentiment data relating to German business expectations (IFO) and Eurozone manufacturing sentiment (Markit PMIs) are now on a declining trend. While the euro benefited greatly from accelerating expectations throughout 2017, a recent downturn in sentiment from the region’s key export industry (manufacturing) and largest economy are good reasons to be more cautious going forward.

Business optimism now declining

2-26-2017 EZ data
Source: CESifo Group, Markit Economics


As can be seen above, Eurozone sentiment has declined markedly since the New Year. German IFO expectations were significantly below consensus estimates last week. Preliminary Markit manufacturing PMIs will be confirmed this coming Thursday. Assuming the numbers remain poor, future economic expansion is likely to be more measured in the coming months.


Going long euros an increasingly risky trade

Back in October 2017, we wrote that politics and economics would dominate euro trading. At the time, the ECB postponed its decision regarding the future of quantitative easing to the second half of 2018. Both actual and forward-looking economic indicators also suggested a sunny outlook for economic growth.  Today, rising political risks and a weak pace of future expansion is weighing on the outlook for the euro. As such, buying euros is increasingly risky without a commensurate degree of reward.

Topics: Euro