After a period of relative calm, political turmoil has once again reared its head in the eurozone.
The Italian government appears on the brink of collapse, while Greece has launched a crackdown on Golden Dawn and Germany’s ‘grand coalition’ negotiations have taken an unexpected turn.
Italy’s government is close to collapse following the surprise decision of Silvio Berlusconi to withdraw his five PDL party ministers from Enrico Letta’s ruling coalition. His stated reason is the increase in VAT to 22%, but the move comes as Mr Berlusconi faces expulsion from the Senate following his conviction for tax fraud. The withdrawal of the PDL ministers leaves Mr Letta seeking urgent parliamentary support for a new government. He has asked parliament for a confidence vote on Wednesday.
The situation remains very fluid and there are a number of possible outcomes. Some members of the PDL or 5 Star Movement could defect in order to support a new government led by Mr Letta. Alternatively, fresh elections may have to be called, which could feed further political instability as the new electoral law has not yet been passed, meaning the result could be another hung parliament. While this plays out, Italian equities are likely to be volatile, especially the banking sector and stocks connected to Mr Berlusconi.
Meanwhile, tensions are on the rise in Greece after the arrest at the weekend of the leadership of the far-right Golden Dawn party, which has 18 seats in parliament. The charges relate to participating in a criminal organisation. The matter now rests with the courts, but the situation could prove potentially destabilising, with a risk of social unrest.
Over in Germany, Angela Merkel’s resounding victory in the recent election is a significant vote of confidence in her handling of the eurozone crisis. However, the failure of her Free Democrat (FPD) allies to secure at least 5% of the votes means we are in a period of uncertainty as she tries to form a ‘grand coalition’ with the Social Democrats (SPD). This process could take some weeks, particularly as the SPD has said it will put any coalition agreement to a party referendum. This raises the spectre that a deal could be reached between the party leaders, but rejected by the SPD members. Ms Merkel does have the option of negotiating instead with the Greens, but this is likely to be less popular with her own party.
We would view a period of weakness in European markets as an opportunity to become involved in what we perceive to be a ‘recovery story’ for the European economy. Leading indicators including business PMIs and consumer confidence surveys have ticked up recently, reinforcing the better than expected Q2 eurozone GDP growth which came in at +0.3%.
Corporate earnings expectations in Europe remain subdued with current forecasts some 30% below the 2007 peak, whereas in the US profit margins and earnings are already well above historical levels. When looking at valuations, European CAPE* multiples are below 15x versus history at 22x and the US on 25x.