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How political events in Europe may impact Asia markets

THE European Union is of critical importance to Asian growth, access to credit and financial risk markets. Therefore, the dizzying rise in political risk across Europe rightly occupies the minds of Asia's investors and policy makers alike.

We see three possible scenarios which might play out in European politics over the next year, within a positive, neutral and negative framework. In all three scenarios, we summarised our thoughts on their likely impact on global and Asian currency, equity and bond markets.

Notable events in Europe

As Asia-Pacific's largest trading partner, the EU matters. Economic ties with Europe directly influence the region's growth potential, the ability of local corporates to access bank credit and, of course, the performance of Asia's currency, equity and bond markets. It is no surprise then that the dizzying rise in political risk across Europe - which carries profound implications in terms of future multilateral cooperation - should so seriously occupy the minds of Asia's investors and policy makers alike.

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The recent victory in the Netherlands of the centre-right People's Party over the populist Freedom Party was greeted with relief to the extent that a wave of anti-EU, anti-euro opinion sweeping across the continent appeared to have been exaggerated. However, challenges posed by elections in France, Germany and Italy, coupled with Brexit negotiations, will ensure political risk remains of critical importance.

In order to assess the possible impact of each scenario on Asian markets, we highlight the main takeaways of each possible outcome and suggest some possible Asian reactions.

Scenario (Positive): 'Ode to Joy'

This "Goldilocks" outlook carries a likelihood of 30 per cent.

In this scenario, Greece receives the next tranche of its bailout, and countries like France, Germany and Italy choose mainstream candidates. EU macroeconomic data continues to improve. Banks do well; equities do well; Bund yields rise; and a mid-year European Central Bank (ECB) tapering debate elevates the euro. In fact, we think markets are already close to pricing in this positive scenario.

Likely impact on Asia

  • Equities - markets should react positively with exporters leading the rally as they benefit from diminishing political uncertainty and the likelihood of a sustained EU demand. Nascent earnings expansion evident across Asia is likely to continue.
  • Fixed income - higher EU and US yields are unambiguously negative for Asia's local currency-denominated bonds. Short-dated Asia USD high yield bonds are likely to outperform on improved market sentiment and higher US treasury yields. Any sell-off in USD credit will represent a buying opportunity given the voracious local appetite for the Asian USD risk.
  • Forex - in a more complex sequence, US rates and yields rise further and faster as a positive EU outcome emboldens the US Federal Reserve (Fed) to bring forward the next rate hike, supporting USD strength. Initially, however, a relief rally in the euro is likely first, lending support to the equity risk above.

Scenario (Neutral): 'Riddle of the Sands'

This "muddling through" scenario carries a likelihood of 50 per cent.

In this neutral scenario, the uncertainty over Greece continues, France's Emmanuel Macron is elected president, only just, but uncertainty remains over his government. There is no real progress made in Italy, and thus, EU economic data indicates only moderate stability. Stretched valuations point to downside in equities and peripheral risk. Reduced taper talk a growing risk for the euro.

Likely impact on Asia

  • Equities - in the absence of a clear direction from Europe, focus will return to domestic fundamentals with cyclical recovery in China likely to support regional markets.
  • Fixed income - hard and local currency bonds are likely to remain steady as domestic demand for yield outweighs ECB tapering-led funds outflows from Asia.
  • Forex - gradual rate hiking trajectory from the Fed to continue, keeping the USD firm but limiting upside. Remaining uncertainty in the eurozone ensures downside pressure on euro; and any counter trend rally, weak.

Scenario (Negative): 'Inferno'

This "apocalyptic" scenario carries a likelihood of 20 per cent.

In this least likely scenario, Greek and Italian woes deteriorate; in France, Marine Le Pen wins but has the parliament against her; Germany sees a battle between Angela Merkel and Martin Schulz. Therefore, the eurozone growth falters, thus leading to deteriorating credit fundamentals. Redenomination risk and political uncertainty exert pressure on sovereign credit, resulting in another EU and euro crisis.

We are likely to see EU equities, credit, bank securities and periphery debt experience pressure. Bunds and core government bonds rally and bonds with longer maturity would outperform. Euro dips below parity but only just, as the ECB's contribution is limited by moral hazard. This scenario is not at all in the price.

Likely impact on Asia

  • Equities - global risk-off environment and tighter credit conditions weigh on Asia's growth outlook and regional equity markets. Trade-oriented economies and cyclicals are likely to underperform, while Reits should witness renewed interest as the US Fed potentially delays rate hike cycle.
  • Fixed Income - Asian high yield experiences selling pressure while USD-denominated investment grade bonds are well supported. Asian local currency bonds benefit on safe haven bid, but weaker Asian currencies will generate losses for USD-based investors.
  • Forex - Asian currencies fall as investors flee to safe haven assets: the CHF and JPY. Pace of Fed rate hikes dialled back although USD likely to maintain its strength.

It remains to be seen how these key events will pan out in the EU, but it is clear that the futures of Asia and the EU are closely intertwined. Overall, global investors are cautiously optimistic ahead of the French election in April. In this environment, we remain upbeat on China equities in anticipation of political stability and cyclical recovery, expect Asian USD bonds to be resilient due to the ample demand and continue to see renewed weakness in most Asian currencies, led by the CNY.

  • The writer is CIO, Asia-Pacific, Credit Suisse
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