Politics and Markets: Won't Get Fooled Again? - Wall Street Journal
Shocked by both June’s Brexit vote and November’s victory for Donald Trump, investors are acting sooner and more decisively on political risk. That portends greater volatility in markets.
In the short term, the political-risk trade sent shares of Italian banks down Monday on the first day of a bailout plan and a week ahead of a constitutional referendum. More significantly, investors are starting to react to the French presidential election, which is still several months away.
Developed markets have tended to react late to political risks and to assume that the status quo will hold. The orthodox political thinking is still that National Front leader Marine Le Pen won’t become France’s next president. The polls instead favor François Fillon, who won the center-right primary at the weekend, in a runoff against her.
But already, the 10-year yield spread between France and Germany has reached more than 0.5 percentage point, its highest since early 2014. The spread started widening straight after the U.S. vote, and hasn’t really stopped since. It isn’t necessarily cause for particular alarm: Yields on 10-year French debt are still ultralow, at 0.76%. The last time the spread to Germany was at this level, the yield was north of 2%.
But the widening is still noteworthy, as it goes against the trend of compression induced by the European Central Bank’s government-bond purchases. Normally they would suppress volatility and hence keep spreads tight in the absence of a near-term catalyst.
A similar development has occurred in Italy ahead of the country’s Dec. 4 constitutional referendum. Here, a “yes” vote, which would allow Prime Minister Matteo Renzi to push ahead with reforms, would be the surprise. Like the French spread, the Italian 10-year spread against Germany has widened to levels not seen since early 2014.
But investors are clearly jittery about the risks for Italian banks, whose balance sheets remain burdened with bad loans. The poster child is Banca Monte dei Paschi di Siena, whose shares dropped Monday as it launched a debt-for-equity swap, the first step in a broader recapitalization. But share prices for big Italian banks like UniCredit and Intesa Sanpaolo also fell by some 4% to 5%.
In some ways, greater political awareness is a welcome development. Investors in developed markets have long appeared complacent in comparison with emerging markets, where there is often a political risk premium.
But a greater focus on politics and a back seat for monetary policy also raise the risk of sharper moves in markets. The ECB warned last week of the potential for the repricing of risks to challenge financial stability. Markets that take more notice of the chance of outcomes that were previously dismissed as unrealistic will be more volatile.
Write to Richard Barley at richard.barley@wsj.com
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