European Risks and Imbalances: Brexit, Trade, Market Volatility, Geopolitics, Populism
The article is a fragment of the "Hope Overcomes Fears As The Fundamentals Propel Europe Forward" report.
High, Increasing. CHANGED (previously high, stable). At this juncture, a disruptive Brexit continues to represent a material downside risk for the region but only feeds into our base case rating assumptions, in a limited way for now, despite the polarised and divisive nature of the political debate. Why? Because we expect a two-year transition period to be agreed in the next two months to prevent unnecessary disruption in March 2019.
The uncertainty involved in this political process is already starting to weigh on business planning for all companies operating in, or selling into, the UK and in our view, the economic impact will become more tangible in the absence of a definitive transition agreement as we progress through 2018. Certainly, private sector business investment has stalled since the start of 2016, although, interestingly, general government investment growth has picked up a little this year. Currently, risk tolerance remains quite low for UK businesses that might increase borrowing to invest in growth.
Nevertheless, reaching agreement on the final end state by early 2021 is by no means guaranteed. Therefore, UK and EU governments and businesses still need to make preparations to minimise the dislocation that could materialise in early 2021.
Asset price volatility
High, stable. CHANGED (previously elevated, stable). With few signs of inflation moving back toward 2%, we expect the European Central Bank's main refinancing rate to remain at zero through 2017 and 2018, which is likely to see credit conditions remain highly favorable for borrowers. Long-term negative real government yields in Germany and the UK remain exceptionally low by any historical comparison. This could inflate European asset prices further, with macro-prudential measures deployed, where appropriate, to dampen down excessive risk-taking in specific areas. The clear risk, if the market runs ahead, is that eventually some trigger such as a faster than expected tightening by the US Federal Reserve or tapering by the ECB could cause an abrupt and disorderly repricing of risk. Past experience suggests this could have unexpected real economic side-effects and lead to more constrained credit conditions, including in emerging markets.
Elevated, stable. CHANGED (previously moderate, stable). Illegal immigration continues to be one of the most important issues facing the major European countries according to the latest Eurobarometer survey. And lack of sufficient integration among communities fuels the terrorist threat that is another top concern, albeit heightened in those countries that have experienced terrorist attacks in recent years. More broadly, geopolitical risks continue to evolve, with the latest twist in the Middle East being the risk of political upheaval in Saudi Arabia inflaming relations with Iran, while the North Korea nuclear threat to the Pacific appears no closer to resolution. Any material escalation of any of these risks could trigger an uncertain sequence of events that would quickly lead to rising risk aversion and undermine growth regionally and, potentially, even globally.
Elevated, stable. UNCHANGED. The main near-term threat to global trade stems from the US Administration's pursuit of bilateral trade deals to replace or rebalance long-standing multilateral treaties in favor of the US. The outcome of NAFTA negotiations has become less certain in recent months and any adverse developments would be especially damaging for Mexico. Additionally, this could undermine confidence in the benefits of free trade and in the World Trade Organisation (WTO), leading to a reversal in the recent improvement in global merchandise trade volumes seen in 2017. Well-established global supply chains in sectors such as automotive, aerospace and defence, and transportation would face disruptions.
The prospective exit of the UK from the EU could create similar trade disruptions if Brexit talks break down before March 2019. However, our base case remains that as of that date, a two year transition arrangement should provide the politicians sufficient time to negotiate a new long-term relationship with the UK once it has left the single market and customs union.
Elevated, stable. UNCHANGED. Appearances can be deceptive. Although no Eurosceptic parties have been elected to government in the major countries in Europe, the growing anti-establishment groundswell (even in Germany) is creating an identity problem for smaller coalition parties. The result is greater polarisation and more populist policies being adopted by the smaller parties. The simmering political tension between Catalonia and the Spanish central government is another example. At this stage we have no visibility on the possible composition of a new Catalan regional government or on its policies and approach towards Spain's central government.
As a consequence, we continue to view political fragmentation as a response to the underlying causes of populism, namely excessive youth unemployment, high-income inequality and immigration linked to wage stagnation, as a meaningful medium-term risk in Europe. Assuming the Social Democrats in Germany do a volte-face and provide at least maintenance support for a minority CDU/CSU government, the Italian election due by May 2018 will likely provide the next important yardstick.
Table 1: Global Risks and Imbalances: Geopolitics, Asset Prices, Trade, Populism, China Debt, Cybersecurity