Drawing a line under both of these situations will help European equities deliver improved relative performance within a global equity portfolio, and banks will play a key role in this.
The dampened enthusiasm for European equities can be explained in part by varying, but persistent political risks. One such risk is that of a ‘hard’ Brexit. In this scenario, the United Kingdom would leave the European Union on 29 March 2019, without a transition deal, on the assumption that a new treaty will be agreed governing future trade relations between the two. It would, however, put an immediate end to the smooth trade between the UK and the continent. The implications would include import duties and inspections at the Irish border. Partly because of this, the movement of goods and people would take longer to process, potentially causing very long delays, and a physical border would have to be re-established between Northern Ireland and the Republic of Ireland.
A ‘hard’ Brexit would probably trigger a recession in the UK, which would hurt economic growth in the EU, too. It is much more likely, however, that the UK and the EU will reach a transition deal, thereby temporarily postponing key strategic decisions − theoretically until December 2020 or a few months thereafter, but in practice probably much later. The advantage of this scenario is that, economically speaking, nothing would actually change.
So after 29 March 2019, European markets will no longer have the British sword of Damocles hanging over them. But the timing of a solution to the Italian crisis is a lot less certain. The Italian government decided unilaterally to renege on its pledge to reduce its budget deficit and is making very optimistic assumptions about future economic growth. The resulting conflict with the European Commission could drag on for a long time, eventually resulting in a modest fine. This will not have a preventative effect.
More importantly, the risk premium on Italian government bonds has risen considerably, which is undermining the financial position of Italian banks, as they hold large positions in these debt instruments. These banks may be forced to raise additional capital in the foreseeable future. But because they probably can't access the capital markets, the government will be forced to step in. In addition, Italy’s credit rating has fallen to worrying levels. If it drops even slightly further, this could jeopardize the assistance provided by the European Central Bank.
There is speculation that the Italian government is pursuing a strategy aimed at helping populist parties secure a resounding victory in the 23 to 26 May 2019 European elections, in hopes of changing the rules of the Stability and Growth Pact. This doesn't seem like a promising approach, as these parties are not likely to garner the support needed from the left and right to achieve a majority. It’s also doubtful whether the Italian government's current stance is going to win it many friends among the other populist parties, either.
Moreover, the European Parliament is basically toothless. It cannot change the pact. It can vote against a new Commission, but then the current one would stay on. The end of May 2019 also seems like a long way off given the stress on the financial markets. The Lega has close ties with the business community in Italy’s affluent north, which probably isn't going to be too excited about a strategy that might lead to a costly Italexit.
We think therefore that the Italian government will eventually give in and reach a compromise with the Eurogroup. This could cause the risk premium on Italian government bonds to fall, thus alleviating doubts about the sustainability of Italy's debt.
Drawing a line under both of these situations will help European equities deliver improved relative performance within a global equity portfolio, and banks will play a key role in this. The elimination of two key downside risk factors will give the ECB more room to start normalizing interest rates. Long-term German Bund yields will rise, once a high risk premium no longer needs to be priced in to compensate for the risk of a Eurozone collapse. And yield curve normalization is of course good news for the European banking sector.