European political risk – trouble brewing beneath the calm exterior?

James McManus

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This past weekend saw the re-election of Angela Merkel as chancellor in the German federal elections. But while this result may have been relatively straightforward by European political standards, there remains much under the surface to potentially worry investors.

Merkel stays, but…

Angela Merkel won her fourth term as chancellor in the German federal election held on the 26th September.

However, the attention hasn’t been on her win. Instead, headlines have been dominated by the rise of the far-right leaning Alternative for Germany (AfD) party, who came in third with just under 13% of the vote. The rise of the AFD significantly alters the political landscape in Germany, not least because this is the first time in over a half a century a far-right party has gained seats in the Bundestag.

While coalition governments are nothing new in German politics, Chancellor Merkel now has the challenge of uniting three parties with significant policy differences (the CDU/CSU, Free Democrats and Greens currently look set to be the most likely combination for a coalition).

There is no precedent for how a three-party coalition could work in practice, but what is certain is that Ms Merkel will preside over a coalition in which she has less power than her previous three terms.

The process of building a coalition could take some time, and it’s possible that Germany won’t have a working coalition in place for many months. Coalition building will require compromise, and while the Green party is buoyed by a better-than-expected result and appears keen to work with Ms Merkel’s CDU, the Free Democrats will want a firm footing in any government after losing their junior coalition with the CDU in the 2013 election.

Do the new dynamics raise questions over eurozone reform?

While we’re still at the early stage of negotiations, investors are already beginning to analyse the ramifications of the new German political landscape, both domestically and for the wider European region. Germany is the EU’s powerhouse economy, accounting for over a fifth of EU GDP, so it has a dominant voice in eurozone politics.

As such, German support is generally needed to advance any reform of the eurozone, for example Emmanuel Macron’s ambitiously proposed budget for the region. However, the Free Democrats have been vocal critics of Mr Macron’s proposals. This of course suggests that the new German coalition may not be as supportive of reform, especially where it believes the German taxpayer will be paying for other countries’ mistakes (the Free Democrats have opposed financial assistance programmes for Greece, for example). Ms Merkel will certainly have less time to debate those wider reforms over the coming months while she focuses on establishing a domestic coalition.

Portfolios positioned for what’s ‘brewing under the surface’

We’ve recently held fewer European equities in Nutmeg portfolios this year than we typically hold over the long term. This was principally driven by concerns over European political risk in the first half of the year, with several major European economies holding general elections.

While European political risk appeared subdued over the summer months, it remains easy to forget that the Netherlands still hasn’t formed a functioning coalition following their March 2017 election, and that the deadline for the next Italian general election – in May 2018 – is fast approaching.

In addition, though the broader European economy has shown signs of recovery, the key driver so far has been a rise in global trade rather than a rise in domestic activity.

Given all these factors, we’ve chosen to own more of other, non-European assets, such as emerging markets equities, that should benefit to a higher degree from stronger global trade.

Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.


James McManus
James joined Nutmeg in 2015 from Coutts & Co. He is responsible for leading the investment management, wealth services, and investment proposition teams at Nutmeg. An expert in exchange-traded funds (ETF), James is regularly quoted in the national and industry press on ETFs, investment funds and ESG investing, and was voted one of Private Asset Manager’s Top 40 under 40, five times between 2017-2021. James holds a BSc in International Business from Nottingham Business School, the CFA UK Investment Management Certificate, and the CFA Certificate in ESG Investing.

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