EuropeanMay 15 2014

EU vote may spur Draghi to intervene

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This provision will apply for the first time in this year’s elections. More importantly, the growth of backing for populist parties threatens to jeopardise the future of the European project. Investors may be tempted to review their allocations to continental Europe depending on their expectations on the vote. Here are some key things to consider ahead of the voting.

Newspapers are finally beginning to pay attention to the upcoming European parliament election. They are especially noting the growing support for populist parties, such as France’s radical right-wing Front National party and Britain’s headline-grabbing Ukip.

Still facing the headwinds of austerity policies imposed by the European Commission, some voters blame the European Union for rising unemployment, poverty and lacklustre economic growth. This election provides a prime opportunity for them to express their anger, with the populist parties being best positioned to capitalise on this disdain.

Unlike previous elections, a number of these populist parties are openly willing to cooperate in the European Alliance for Freedom, as announced by Geert Wilders and Marine Le Pen on the 13 November 2013.

According to the most recent opinion poll, the Eurosceptic party, European Conservatives and Reformists, are projected to have 40 seats while the anti-Union party, Europe Freedom and Democracy, is expected to get another 30. With approximately 10 per cent of the parliamentary votes, their anti-union sentiment will weigh on future decisions taken in Brussels.

Although EU institutions such as the parliament and national governments are bound by treaties to respect the European Central Bank’s independence, the upcoming vote could affect ECB policy. The election of ECB president Mario Draghi, and the more accommodative stance taken by the ECB since his appointment, illustrated that the Governing Council of the ECB is not a self-governing body, but instead influenced by the parliament itself. Therefore, to forecast a change in the ECB’s policy after the election would be reasonable, depending on the broad voting result.

What is more, the European Union is founded on the principle of solidarity between nations, part of which saw the 27 member states (Croatia joined after the deal was struck) agree to incorporate the European Financial Stability Facility. The EFSF’s mandate is to safeguard financial stability in Europe by providing financial assistance to eurozone member states. Following the Greek bailout in 2010, the EFSF agreed an €85bn (£70bn) rescue package for Ireland in November2010 and a €78bn (£64bn) bailout for Portugal in May 2011.

In the event of a dramatic rise in anti-EU parties at the election, eurozone solidarity would once again be brought into question. The resurgence of the European debt crisis cannot yet be ruled out. If investors are concerned by this possibility, then after having enjoyed strong returns over the past two years, now could be a good time to begin moving out of Europe. As a reminder, the IMA Europe excluding UK sector has averaged a return of plus 44.82 per cent over this period.

However, a number of political scientists have countered the idea of success for anti-European Union parties, claiming that the electoral progress of these parties is negligible and that their influence on the daily activities of the European parliament is likely to be insignificant. Nevertheless, European institutions cannot ignore this electoral growth. The fear of deflation is a large concern for the ECB.

Mr Draghi explained on 25 April this year that: “The objective here would not be to defend the current stance, but rather to increase meaningfully the degree of monetary accommodation. The governing council is committed – unanimously – to using both unconventional and conventional instruments to deal effectively with the risks of a too-prolonged period of low inflation.”

Following the example of the US Federal Reserve and Bank of England, the ECB might be tempted to initiate a quantitative easing programme. Based on these past examples, small and medium-sized market capitalisation companies can be expected to benefit the most from this scenario. Therefore investment advisers should recommend investing in funds with a strong focus on European smaller companies; one example being the Baring Europe Select fund.

Investing in European smaller companies is no easy task, so manager Nicholas Williams’ extensive experience is a valuable addition to this fund. His process is simple but reliable and has been tested during difficult periods. The market for European smaller companies has been inefficient in recent years and the manager has been rewarded for his ability to identify high-quality companies and for maintaining his strong sell discipline. Although the fund has generated strong performance, this comes with an above-average level of risk, which is a feature that investors will have to acknowledge before buying into it.

Another concern for the ECB is the current valuation of the euro. Speaking after the spring meetings of the International Monetary Fund, Mr Draghi said the strengthening of the euro “requires further monetary stimulus”, highlighting the link between the ECB’s policy and the value of the euro currency.

Christian Noyer, governor of the Banque de France, claimed the euro was abnormally high. He argues the appreciation of the euro in recent years has been particularly detrimental to the French economy and its exports. Contrary to high value-added products exported by German manufacturers, the French’s balance of trade is particularly sensitive to the euro’s international value. So far, no action has been taken and it is likely German firms will keep benefiting from the euro’s appreciation.

Investors might be tempted to play the German export theme, selecting funds focused on German equities. It is worth highlighting the Baring German Growth fund, which aims to profit from the dynamic nature of the German economy, in particular its exporting power. The portfolio is also very well diversified, with a high number of small and medium-size companies.

Contrary to this pessimism towards European stability and euro appreciation, investors should be aware of the European recovery theme. The recovery from its sovereign debt crisis recently took two significant steps forward as Greece posted a primary budget surplus, allowing the creation of a more lenient bailout repayment schedule; and Portugal made a successful return to the bond markets for the first time in three years independent of rescue fund aid.

This may appear a risky bet, but there has been plenty of evidence showing the economies of Portugal, Italy, Greece and Spain are bouncing back – the nicknamed Pigs countries.

Some fund managers are trying to profit from the recovery in Pigs, particularly as the valuation of their domestic banks was slashed during the debt crisis.

The manager of the highly successful Henderson European Selected Opportunities fund, John Bennett, decided to invest in these banks because they are the most correlated to the European Purchasing Managers’ Index, a leading indicator of business sentiment. Several names have been added to the portfolio recently, as is highlighted in the fund’s increased exposure to financials over the past two years.

Clearly investors are facing many scenarios ahead of the European parliament election, ranging from a breakup of the eurozone to a recovery extending out to the Pigs countries. This is also the case for European fund managers, who will all have their own outlook on the region, with their portfolios positioned differently as a result. Fund selection will be of paramount importance for investors looking for European exposure, particularly if they want their portfolios to reflect their expectations of May’s election.

Charles Younes is a fund analyst at FE

Key points

With the European parliament elections in the offing, the growth of backing for populist parties threatens to jeopardise the future of the European project

The upcoming vote could affect ECB policy

Contrary to this pessimism towards European stability and euro appreciation, investors should be aware of the European recovery theme