After a year in which the European investment agenda was dominated by political factors, we expect 2018 to bring a greater focus on economic fundamentals. However, taking a closer look, we expect political factors to return to the agenda due to the unfolding of all the consequences of the UK's exit from the European Union.
In particular, we believe that the Brexit it will have a significant impact on the trade bloc's balance of power and its modus operandi.
The election of Emmanuel Macron as French President and the reconfirmation of Angela Merkel as German Chancellor, both supporters of greater European integration, suggest to us that the pro-EU political leadership is probably more solid than it has been for many years now.
We therefore believe that at least in 2018 political factors will take a back seat and that markets will be more focused on the course of the European Central Bank's monetary policy, as well as on macroeconomic data.
In our opinion data on growth in Europe are generally positive, although there are reasons to be cautious. Some regions are weaker than others, and inflation across the eurozone remains well below the ECB's 2% target, all of which continue to justify its continued accommodative stance. In our view, the ECB is likely to extend its quantitative easing (QE) program until shortly after September, its current time horizon.
Similarly, we expect the ECB to start raising interest rates only when QE is largely completed. We therefore expect that an interest rate hike in the Eurozone will take place no earlier than 2020-2021.
On the other hand, the composition of the ECB is expected to change over the next 18 months. Mario's mandate Draghi the presidency of the ECB will end in October 2019 and several other members of the governing council are also expected to step down next year.
Taking all these factors into account, we expect bonds in Europe to stay within a price range over the course of the year. Yields could rise slightly from current levels, but we don't believe there will be substantial increases unless inflation becomes much more solid not only in Europe but elsewhere as well.
However, we see some potential sources of opportunity in some European currencies, notably the Norwegian krone and Swedish krona, which have seen a decent correction recently.
La Brexit threatens to shift the balance of power within the EU in the long run
Given the storm currently raging, we believe the UK and the EU will eventually reach some kind of Brexit deal.
Some European countries, in particular Ireland and Germany, could suffer a major blow if the UK leaves the EU without a deal. We therefore believe that those European areas will probably make every effort to ensure that some kind of agreement is reached, even if it is not necessarily the best for all parties.
In the longer term, however, in our view the UK's exit from the EU could start to reveal different attitudes between different factions within the trading bloc and could result in the balance of power shifting in the European Parliament towards countries of the Eurozone.
Countries such as Germany and France want a more integrated EU, while others, for example in central Europe, prefer a less coherent group, one that offers them trade benefits but at the same time allows them to maintain greater control over their sovereignty.
Under European Parliament law, a vote or veto needs 67% to pass. Currently, Eurozone countries account for around 70% of the vote in the European Parliament, while non-Eurozone countries, such as the UK, make up the remaining 30%.
Therefore at the moment the dissent of a single Eurozone country could lead to the negative outcome of a vote. After the exit of the United Kingdom, which represents 12% of the votes of the European Parliament, the voice of the "non-euro" countries will however have less strength.
We believe that as a result the EU will be much more likely to become a “euro club". Countries that have not adopted the euro could revise their position if they want to have a say in the future of the bloc.
Similarly, the UK has tended to take a tougher economic approach to the EU budget, often voting with other northern European member states (including Germany) against spending increases.
When the UK is gone, countries in favor of increased EU spending could find themselves in the majority, potentially winning the vote even in the face of possible German opposition.
In our view, this situation too could create some different dynamics within the trading bloc, though probably not in the immediate future. We therefore believe that European policymakers are already starting to organize themselves to deal with this changing situation and we believe it is a development that investors should monitor.
