Asset Management

European election results and economic fears drive market volatility

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
Joseph Higgins, Managing Director, Fixed-Income Portfolio Manager

In this special edition of the weekly market update, we summarize our perspective on the latest developments in Europe and their likely impact on the markets.

Volatility in the financial markets intensified this week in the wake of recent national elections in France and Greece. The shifting political landscape in those countries has sparked renewed fears about the European Union’s ability to resolve its economic, fiscal and sovereign debt problems. Investors are worried that progress on these issues could be derailed, with potentially negative consequences for the regional and global economies.

France: Reality versus perception suggests less upheaval than feared

  • As pre-election polls had predicted, French president Nicolas Sarkozy was defeated by François Hollande of the Socialist Party. Investors had priced in a Hollande victory ahead of the voting, and market response was muted in the immediate aftermath of the election.
  • Although the rhetoric of these two leaders is dramatically different, in practice we believe Hollande and Sarkozy are not as far apart as one might suspect. We do not expect France, under a Hollande presidency, to break from current policies or previously agreed-upon treaties and agreements. Moreover, we think Hollande will have to tread fairly lightly, as he won the election by less of a margin than forecast.
  • However, it is possible that we will see a slight shift in emphasis toward stronger growth measures with somewhat less focus on austerity, as the worsening recession in Europe makes it difficult for governments to promote economic expansion while simultaneously seeking to reduce debt.
  • We may also see some willingness on the part of Germany to make small concessions on austerity demands as a way to smooth its relationship with France, while keeping the region’s fiscal compact on track. Any “give” by Germany on regional economic and financial policy will be limited by its own domestic political considerations.

Greece: No majority means another election and more volatility ahead

  • The Greek election produced the feared worst-case scenario: no majority winner, and no success at building a coalition government among the largest vote-getters. As a result, Greece will have to hold a second election in June.
  • Preliminary data suggest that heavy turnout among young voters helped the far-left, anti-bailout Syriza party garner a second-place finish, while many older voters apparently boycotted the election.
  • Markets are hoping that, after digesting the fractious outcome of the May election, the Greek electorate will refocus on the high stakes for Greece’s economy in the June vote. If older (and presumably more conservative) voters turn out, pro-bailout parties have a better chance of being re-elected, particularly since polls indicate that 70 percent of Greeks wish to remain in the European Union (EU).
  • That said, the likelihood that Greece will exit the euro has risen. A primary concern is that a Greek breakaway from the EU could trigger a systemic event involving European banks — perhaps beginning with a run on deposits in countries such as Portugal and Ireland, as deposits in the Greek banking system are exchanged out of euros and into drachmas (the Greek currency). A true “firewall” to contain such an event would require a guarantee of deposits in those countries to prevent bank failures.
  • We do not think a broad systemic failure of this type is the most likely scenario, but in terms of potential impact, such an event would pose a greater threat to the global economy, and to U.S. GDP growth, than a recession in the eurozone.

Looking beyond the elections
While the markets continue to fixate on fear, we remain focused on a broader range of factors and data that inform our perspective on the direction of the economy and the markets. For example, production numbers from Germany came in better than expected this week — a positive counter to weakness elsewhere in the eurozone. Additionally, with the recent sell-off in European equity markets, stocks in the region have begun to appear attractively valued, which could present selective opportunities.

Ultimately, there will need to be some type of end game to the crisis in Europe, through which liabilities are shared and economic growth is jump-started in some way —possibly with impetus from continued expansion of the U.S. and Chinese economies. With the U.S. facing its own degree of fiscal pain and political brinksmanship in the coming months, investors should expect to see continued volatility.

Statement regarding limited exposure to European securities in TIAA-CREF portfolios