What do we think about Europe?

The following is a transcript from a recent interview of Montaka’s Andrew Macken by an Australian journalist.

What are the possible market-friendly political scenarios?

The friendliest scenarios for markets are those in which right-leaning Euro-skeptic political parties or leaders do NOT come to power in major European nations such as Germany, France or Italy.

Or said another way, the scariest scenarios for financial markets are those in which Euro-skeptic politicians gain enough power in the major European nations to call an EU-membership referendum. Ultimately, if a major nation such as Germany, France, or Italy leaves the EU, it is highly unlikely the EU would survive this. And the abandonment of the Monetary Union will almost certainly result in sovereign debt defaults. European sovereign debt is held by almost all European banks and insurance companies with essentially zero capital held against these assets to absorb losses (as sovereign debt was typically viewed as being “risk-free”). Therefore, the write-down of public debt by a major European sovereign would materially impair the equity of nearly every bank and insurance company in Europe.

This is an extremely financially-turbulent scenario that currently has a low probability of occurrence. But depending upon the outcome of certain impending events (Italian Referendum, French and German elections next year), this probability could rise significantly.

How are you viewing Italy’s referendum on Sunday?

If the referendum passes, the reforms will empower the government to more easily effect change; and Prime Minister Renzi’s leadership will be consolidated.

The market will likely favor this outcome of the referendum, though less so because of the constitutional changes that will result. A favorable market reaction will simply stem from the absence of the referendum failing.

If the referendum fails, the fear is that Italy is sent to new elections. It is not a certainty, but the probability of fresh elections definitely increases materially if the referendum fails. New elections risk the rise of the Five Star Movement who have vowed to call a referendum on Monetary Union membership. So the fear is that a failed referendum on Sunday could be the first step in a path towards Italy leaving the Monetary Union. And this would trigger the turbulent events described above.

What about for the French election next year?

Similar to the above, the market’s concern over next year’s French election is that Marine Le Pen wins. The concern stems from Le Pen’s promise to call a referendum on EU membership. The fear is that a Le Pen victory could be the first step towards France leaving the EU; and a resulting break-up of the Monetary Union.

Taking a step back, what is the EU’s problems and how do we solve them?

In essence, the EU’s problem is low economic growth and resulting weak employment.

Fiscal policy (direct government investment into the European economy) would boost EU growth, however, the significant indebtedness of European governments has drastically limited EU governments’ ability to invest.

So, what are the options? Crudely speaking the choice is between: (i) a write-down of government debt which would wipe out much of the equity of most European banks and insurance companies but would then allow governments to start investing in their economies again, returning the Eurozone to growth and higher employment longer term; or (ii) sluggish or no growth for decades to come.

Thus far, policymakers have opted for option (ii).

Option (i) would be a quicker fix but would be more painful in the short term. If Germany, France or Italy leave the Monetary Union, we will jump from option (ii) to option (i).

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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