Finding the Positives from a Tumultuous Week in Europe

Developments in Europe, including the resignation of Italian Prime Minister Matteo Renzi and the shock decision of the European Central Bank to reduce the amount of its monthly bond-buying program next year, have contributed to a tumultuous week for investors. Here David Zahn, head of European fixed income, Franklin Templeton Fixed Income Group, offers his analysis of these situations and explains why he sees a silver lining in both instances.

Politics has dominated many global investors’ concerns for the last six-to-12 months, and nowhere more so than in Europe. While I think it’s important to continue to look at the underlying fundamentals, I maintain that politics and monetary policy will be the most important drivers of financial markets over the next year.

For that reason, we were eagerly anticipating the latest pronouncements from the European Central Bank (ECB). Its announcement included confirmation that the ECB intends to extend its asset-buying program until the end of 2017, but to reduce the monthly purchases in April of next year to €60 billion from the current €80 billion.

Initially, a number of investors seem to have assumed this move amounts to a tapering of the program. We have a different view.

The absolute amount the ECB is now expecting to purchase over the lifetime of the program has been increased. In addition, we believe that by removing some of the constraints on the eligibility of assets for purchase, the ECB has enhanced its ability to do quantitative easing (QE) for longer.

While the market is assuming the ECB may not be as accommodative, we would think it could be just as accommodative and continue to be so for longer than originally anticipated.

We would expect one consequence of this announcement to be much steeper yield curves in Europe, which implies notably higher interest rates on debt of long-term maturities than on short-term. Outside of Europe, Japan’s authorities have also indicated that they are looking for steeper yield curves, so investors may want to consider whether their portfolios are positioned for this to emerge as a long-term trend.

It’s also worth noting that ECB President Mario Draghi and his colleagues have demonstrated they are conscious of the potential political risks on the horizon; the ECB statement at its latest meeting explicitly notes that it could increase the buying program again if it deems it necessary.

The Italian Connection

Meanwhile, markets in general seem to have shrugged off the defeat of Italian Prime Minister Matteo Renzi in his country’s constitutional referendum and his subsequent resignation. Unlike other plebiscites this year—namely, the United Kingdom’s European Union (EU) referendum and the US presidential election—the result was largely in line with expectations and any perceived negative sentiment seems largely to have been priced in.

More significant, in our view, will be how the situation in Italy plays out from here. Our view is that an early Italian election is unlikely; we think there needs to be some kind of electoral reform to ensure the electoral process can work appropriately.