global perspectives

Europe remains exposed to political risks.

Europe remains exposed to political risks.
Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist
Charles St-Arnaud - Senior Investment Strategist

Charles St-Arnaud

Senior Investment Strategist

For our latest view on the Brexit negotiations, please click here.

When it comes to growth outcomes in Europe, we expect trend growth dynamics and see the recent slowdown especially in Germany as temporary. Beyond cyclical factors, political risks in Europe, however, are likely to remain elevated going into 2019.

Following the arrival of the populist government in Italy, we warned that Italian assets were at risk given the high likelihood of a confrontation between the Italian government and the European Commission (EC) over the budget plan.

Since then, Italian sovereign spreads have surged by about 200bp, sharply increasing the financing cost of the government. The Italian government plans to increase spending and lower taxes that will increase the fiscal deficit significantly in the years to come. However, it is clear when examining the growth assumptions underlying those estimates that the government is expecting a high fiscal multiplier from its stimulus. Those growth rates are about 0.5 percentage points higher than consensus and, as a result, private sector economists expect that the current fiscal plan will lead to a small increase in the debt-to-GDP of Italy. The EC has rejected the Italian government plan, arguing that it is in breach of the Eurozone’s budget rules, and has asked for a revision. This was met with defiance by the Italian government.

Our base case scenario is that Italy will remain in the euro area and that the Italian government will back down and present a budget that is compliant with the EU rules (who may also offer some concessions). However, the road to this outcome will be volatile and risky, especially since we believe the Italian government will only back down in the face of extreme market pressures, as opposed to pressure from the EC.

Essentially, we think the Italian government could end up playing a high-stakes game of chicken with the EC. The populist government understands that if Italy were allowed to fall out of the common currency that could cause significant collateral damage to the rest of the Eurozone, and it is likely expecting the EC to back down first.

In our view, this means further increases in Italian sovereign spreads, and on the Italian banking sector, are likely in the coming months. Furthermore, the risk of an accident remains high and cannot be discounted. The situation is further complicated by the fact that there are also rising tensions within the Italian populist coalition, especially with the League gaining national support at the expense of the Five Star movement, and this could potentially lead to an early election in 2019.

Political risk also abounds in the UK. On 29 March 2019, the UK will leave the European Union. But this is where the certainty ends. It remains unclear whether the UK and the EU will have an agreement in place by that date.

The UK and the EU have recently reached a tentative divorce deal. The details available suggest that the UK will remain closely aligned with the requirements of the single market, preventing the establishment of a hard border in Ireland. It is not yet clear whether the deal will make it through parliament. The domestic political risks in the UK remain elevated.

Recent political developments witnessed in the aftermath of Prime Minister May’s push for a deal indicate that the most pressing issues have not been resolved and uncertainty around Brexit has once again risen sharply as the deadline nears.

While at this stage, it is still unlikely a new referendum will be held – either on the EU membership itself or on the Brexit deal – the consequences of parliament voting against an agreement would be important and could derail the process.

There are also some political risks on the European side too. We continue to think that ultimately a deal between the UK and EU will happen as all sides have an incentive to push the negotiations to the very end. However, the road to a deal is likely to see pressure on UK assets as they become a party to the ’chaos’. 

If a sensible Brexit is delivered, we see GBP rising to 1.40 and potentially even higher next year
with the possibility to be a big winner of 2019. That said, in the event of a “blindfolded” Brexit, we expect GBP to fall by another 10% as the currency adjusts to reflect the new uncertain reality facing the United Kingdom.

Download the Global Outlook 2019.

important information.


This communication was prepared by Lombard Odier Asset Management (Europe) Limited. The information contained in this communication does not take into account any individual’s specific circumstances, objectives or needs and does not constitute research or that any investment strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes a personal investment advice to any investor. This communication is not intended to substitute any professional advice on investment in financial products. Investors should take care to assess the suitability of such investment to his/her particular risk profile and circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. The information and analysis contained herein are based on sources considered reliable. Lombard Odier makes its best efforts to ensure the timeliness, accuracy, and completeness of the information contained in this communication. 
Nevertheless, all information and opinions, as well as the prices, market valuations and calculations indicated herein, may change without notice. Source of the figures: Unless otherwise stated, figures are prepared by Lombard Odier Asset Management (Europe) Limited. The tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Lombard Odier does not provide tax advice and it is up to each investor to consult with its own tax advisors. 
European Union Members: This communication has been approved for issue by Lombard Odier (Europe) S.A. The entity is a credit institution authorized and regulated by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Lombard Odier (Europe) S.A. branches are operating in the following territories: France: Lombard Odier (Europe). S.A. Succursale en France, a credit institution under limited supervision in France by the Autorité de contrôle prudentiel et de résolution (ACPR) and by the Autorité des marchés financiers(AMF) in respect of its investment services activities; Spain: Lombard Odier (Europe) S.A. Sucursal en España, Lombard Odier Gestión (España) S.G.I.I.C., S.A.U., credit institutions under limited supervision in Spain by the Banco de España and the Comisión Nacional del Mercado de Valores (CNMV). 
United States: Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States or given to any US person. 
This communication may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Lombard Odier. 
© 2018 Lombard Odier Investment Managers – all rights reserved