Blog Posts — June 29, 2018

Stress-Testing Political Risk in Europe

by Christoph Schon, CFA, CIPM

In a situation eerily reminiscent of the build-up to the fateful Brexit referendum, many investors seem to once again underestimate the risk of political upheaval in Europe. Like David Cameron in 2016, Angela Merkel faces significant pressure from nationalist and populist forces in her own country to deal with a crisis that can only be resolved at an international level. So, like the former British prime minister two years ago, the German leader now has to lobby her European counterparts for support to avert a power struggle within her coalition, which could ultimately herald the premature end of her chancellorship. However, given the EU’s well-known resistance to reform, there is a substantial risk that her efforts will fail. It is therefore more important than ever for investors to watch their exposures and analyse potential losses from such a scenario.

The current crisis was triggered by a draft bill from German interior minister Horst Seehofer to turn away refugees from the country’s borders, if they either arrive with no papers, have previously been denied asylum or are already registered in another EU country. Human rights groups argue that the proposition contravenes Germany’s obligations under international accords—such as the Geneva Refugee Convention—as well as agreements with other EU countries.

It is also in obvious contrast to Chancellor Merkel’s own convictions and policies. Even though cabinet ministers in Germany are free to independently implement laws in their area of responsibility, Merkel could still use her authority to issue guidelines (“Richtlinienkompetenz”) to supersede Seehofer’s proposal. Or she could simply dismiss him from her cabinet.

The latter could, however, jeopardize the current coalition, which took more than 5 months to assemble. In addition to being minister of the interior, Horst Seehofer is also chairman of the Christian Social Union (CSU)—the Bavarian sister party of Merkel’s Christian Democratic Union (CDU)—which holds 6.5% of the seats in the German lower house. Losing these votes would take the share of the remaining alliance of CDU and the Social Democratic Party (SPD) to just under 50%, effectively putting the final nail in the coffin of the current government.

Seehofer’s two parallel roles put him in a dilemma. His own party—the CSU—is in the middle of a fierce election battle in its Bavarian home state, after having lost a lot of its traditional, conservative electorate to the populist, right-wing Alternative for Germany (AfD). By being tough on immigration, Seehofer hopes to win some of those disgruntled voters back. But at the same time, he must also be aware that his ultimatum could cost him his and his party’s place in the federal government.

Therefore, in order to buy himself and his boss some breathing space, Seehofer has agreed to give the chancellor time to work out a solution with her European partners before the EU summit on June 28/29. After that, Merkel and the CSU leader will meet again to discuss further steps.

Judging from David Cameron’s experience of trying to get the European Union to reform in order to avert a national crisis in one of its member states, it seems unlikely that Angela Merkel will be able to reach a Union-wide solution. This would leave Seehofer with two options: either withdraw his legal draft and lose face—and potentially further damage the Bavarian election campaign—or proceed with the implementation and likely lose his ministerial post. This would effectively spell the end of the current coalition and government and, unless Merkel can convince one of the other smaller parties to step in for the CSU, could lead to new elections—a prospect that the ruling parties will want to avoid, given their ratings in the latest opinion polls. But even if Merkel decides not to dismiss her interior minister, she might just about survive the crisis, but at the risk of damaging her authority and relationships with her foreign allies even further.

So, what can investors do to prepare for such a scenario? Earlier this year, we published a whitepaper, called The German Coalition Quandary, in which we analysed the possibility of new elections following a potential failure of the coalition negotiations in February. Even though this did not happen at the time, we still think that our findings can be applied again in the current environment. In our analysis, we assumed that the euro could devalue by 15% against the US dollar over a 3-month horizon, based on the experiences of the Brexit vote and UK snap election in June last year. We applied so-called transitive stress tests to a euro-denominated model portfolio, using historical correlations from the second quarter of 2017 (the run-up to the French presidential election) and the 3 months surrounding the British EU referendum to calculate the relevant pricing factor movements.

The results showed severe losses in developed stock markets, ranging from -10% to -3% in the first scenario and between -29% and -17% for the “Brexit” period. Fiscally weaker countries, such as Italy and Spain, were hit harder than, for example, Switzerland and also saw their sovereign risk premia over German Bunds widen more. Highly rated government securities, on the other hand, booked positive returns, while corporate debt underperformed sovereigns due to widening credit spreads. The yen also benefited from its safe-haven status.

If you would like to learn more about stress-testing political risk in Europe, please watch our webinar replay on the topic.