Last month, two important events took place that will have consequences for financial markets over the next six months or so.
First, the Federal Reserve surprised markets by postponing its promised move to taper its $85 billion a month purchases of federal government and mortgage agency bonds under its programme of quantitative easing. Even though the Fed had assessed economic conditions in the US as improving, it seemed worried that since its original announcement interest rates had moved far too much and now threatened economic recovery.
This postponement undermines the Fed’s credibility and diminishes its ability to control long-term interest rates. Sure, the Fed’s decision boosted prices of US treasuries and equities and reduced pressure on emerging markets, thus boosting their asset prices and their currencies. And it helped peripheral eurozone bonds by furthering the global hunt for yield.
So, does the Fed action mean that the big equity rally so far this year will be prolonged? The second event in September might put that rally at risk: the German general election.
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Investors might initially conclude that the big victory for incumbent chancellor Angela Merkel means business as usual. But that would be much too facile a judgement. Merkel has lost her coalition partner, the small-business Free Democrats (FDP) party, which failed to pass the 5% share of the vote threshold needed to enter parliament. So although Merkel’s Christian Democrats (CDU) gained a much bigger share of the vote, it did not amount to an outright majority and she will need to form a coalition with the main opposition Social Democrats (SPD). And contrary to the consensus, that will not be good news for financial markets. Sure, a grand coalition would appear to have substantial majorities in both the lower and upper houses of the German federal parliament, enabling the new government to pass any policies it likes. But the problem is that from the beginning the coalition will be under considerable pressure to break up.
First, SPD espouses policies (higher domestic fiscal spending, increases in the minimum wage and redistributive taxes) that are anathema to Merkel’s CDU. And the CDU’s sister party, the Bavarian Christian Social Union (CSU), will oppose any shift towards adopting these policies and might even veto a grand coalition.
Moreover, on European policy, the SPD stands for the mutualization of peripheral eurozone countries’ debt and a single European financial platform that puts German taxpayers on the hook for foreign bank failures. Apart from the German constitutional court objections to this, Merkel and the CDU oppose this in principle.
The CDU will be threatened from the right by the eurosceptic Alternative für Deutschland (AfD) and the FDP. The CDU risks weakening its popularity if it accedes to SPD demands to provide more bailouts to distressed peripheral eurozone states such as Greece, Portugal or Ireland as the European Union elections approach next May. So Merkel will be reluctant to go along with the SPD’s policies on the peripheral countries.
Also, the SPD will be under pressure to break any coalition with the CDU from the Greens and the leftist die Linke and from a section of its own members who remember how the SPD was weakened in the last coalition.
So, far from endorsing the view (which might well be that of the market in the short term) that a grand coalition is pro growth and pro euro, I reckon that it opens a period of considerable political uncertainty in the eurozone.
As we go towards the end of this year, investors will be uncertain about what the Federal Reserve will do on monetary policy and what the new German government will do about the still difficult task of achieving the funding of government debt in the peripheral eurozone states.
Politics in Italy are paralysed and the government is falling short on its fiscal targets. Greece still has a large hole in its finances and will need another bailout. Portugal is struggling to service its debt and needs help to fund it next year. Ireland wants the eurozone leaders to take over the bailout of its banks, while Spain’s banks remain seriously at risk.
If the Fed finally starts tapering and the eurozone debt crisis returns, a continued financial market rally is far from likely.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com