A wave of anti-government demonstrations is being witnessed around the world this year amid growing discontent due to the policies put in place by governments. Politicians are under immense pressure to find a solution to the fallout of geopolitical decisions, with many questioning the righteous positions of governments in the Ukrainian war, while investors are trying to navigate uncertainty surrounding international relations and political leadership. Europe is the epicentre of social unrest, with public frustration rising following the outbreak of the war, which brought to the fore the issues that were brewing in the undercurrents.
Coupled with rising inflation and the EU's need to reassess its fiscal and security policies, it is likely that the conflict in Ukraine will have long-term economic ramifications too. The war's outcome is still unclear, and should it become protracted, it will drive more refugees across European borders, adding to the financial burden. With protests over rising energy prices and high costs of living already taking hold in Europe, there is an increased potential for civil unrest to deepen in the coming months.
The table below represents some of the geopolitical and social developments occurring recently in greater Europe
Europe reeling from the consequences of the war
The spillover effects of the war are more pronounced in the European Union, as the imposition of sanctions on Russia by the EU and the US over its aggression on Ukraine is backfiring, manifesting through the escalating prices of just about everything. The disruption of the supply chain, exacerbated by the war coupled with the drought in Europe, has resulted in food scarcity and surging food prices. Against this backdrop, regional inflation has risen significantly this year, with the likes of Germany and Hungary reaching multi-decadal highs.
Given the rife inflation pressures in the Euro area, the ECB and other central banks are hiking interest rates to try to combat the stubbornly high inflation. The ECB has so far hiked interest rates by 175bp to 1.25% and signalled that it will remain more hawkish in its forward guidance. With more tightening on the cards, coupled with the ongoing energy crisis affecting productive sectors of economies and high inflation eroding workers' real wages, the economic slowdown in the EU appears to be unavoidable. Regional PMIs have fallen deeper in contraction, supporting the view that growth in the region is faltering. This explains why many regional central banks and multinational institutions such as the IMF, OECD, and World Bank have revised lower their growth forecasts for 2023 as demand will take a significant knock. The latest OECD forecast shows that the EU GDP growth is projected to expand by 2.2% in 2023 (vs 2.8% previously), with the EU economic powerhouse Germany falling into a recession.
Financial Market Analysis
Worldwide, economies are showing signs of a rapid slowdown as they contend with a series of shocks, some of them self-inflicted by policymakers, increasing the likelihood of another global recession and the danger of major financial disruptions. As a result, we are seeing financial stress becoming more prevalent. In the same way, people became anxious in 2008/2009, there are increasing levels of anxiety currently, which were amplified after the Russia-Ukraine war. Still, at the heart of the strain is the fallout from the most aggressive hiking of interest rates since the 1980s, which so far have failed to arrest the surge in inflation to multi-decade highs. The crisis in the UK offers a preview of the dangers other economies could face in an era of high inflation and rising interest rates.
Global bond yields have surged this year as the prospect of tighter monetary policy to combat inflation and recessionary fears. For months, the story has been dominated by the Federal Reserve and its measures taken to counteract inflation. However, Europe's energy crisis and the UK's increased issuance to fund fiscal splurges have damped investor appetite for fixed-income assets. Specifically, Eurozone government debt yields have soared to multi-year highs, with expectations that central banks will keep tightening their monetary policy despite recession risks and a new sell-off in British gilts. But the market appears to be reaching its limit, and pressures are building.
This is particularly clear in the UK, whereby cash is proving to be king amongst pension funds following the funding market shock. On paper, pensions have never been in better shape. But given that pension funds were not anticipating such a large increase in interest rates happening so quickly led to the BoE intervening as it was concerned that collateral requirements on Liability-Driven Investment (LDI) strategies would have turned many pension funds into forced sellers of gilts. It turns out the British government had much less fiscal space than it realised because of the pensions. This can be put down to low rates over a long period creating vulnerability in the pension fund market. Note that British pensions have £1.5 trillion ($1.65 trillion) in assets, and about 20% of the assets are held in direct gilts. In Q1, pensions owned 28% of outstanding UK debt, with a hefty presence at the long end of the curve.
Meanwhile, premiums to hold European bonds over German bonds have risen to some steep levels. The clear standout is Hungary, with premiums rising to 800bp, while the Czech Republic and Italy have the lowest spreads. The spread between Italian and German 10yr yields widened after the rightist coalition won a clear majority in the recent elections. Investors had already priced in a victory of the centre-right coalition, and more clarity about the new government's policy might be needed before any significant change in investors' stance. PM Meloni, during her campaign, pledged to abide by European Union budget rules and put away anti-euro rhetoric, which triggered a sharp spread widening after the 2018 election. Italy's 10yr bond yield hit its highest since October 2013 at 4.52%, while the spread between Italian and German 10yr yields widened to 240bps. Markets will watch the choice of Finance Minister and anticipate a government could be formed by the end of October.
The USD remains king on the back of haven demand and global uncertainty. This contrasts with the EUR-USD that continues to nose-dive as its economy stumbles toward a recession. It's fallen nearly 13% versus the USD this year, hitting levels below parity that have not been touched for twenty years. With intensifying headwinds, such as price pressures, an energy crisis, Italy's politics, and mounting recessionary concerns, Euro selling could intensify in the months ahead. This is despite the ECB beginning its policy normalisation in August with some outsized interest rate hikes as it looks to narrow the interest-rate differential with the US Fed. The narrative remains that further losses are in store for the Euro, and speculators will remain heavily net-short the common currency.
The British Pound has stolen the show for all the wrong reasons entering the year's final quarter. Sterling's meltdown came off the back of the announcement of the new Prime Minister Liz Truss, as investors are worried about whether Truss will be able to cope with the deplorable situation in which the country's economy has found itself. Having failed to recover from Brexit and the COVID-19 pandemic, the UK has faced unprecedented inflation, a decline in household income and a catastrophic currency collapse. Moreover, investors have not responded well to the Finance Ministers' announced borrowing and spending spree. While the BoE may have helped stabilise markets in the short term through its emergency bond-buying programme, and the pound has since recovered, the truth is that the policy background still suggests that the GBP could lose even more ground over the longer term.
At best, the BoE has bought the government more time. For this situation to truly stabilise, the UK government must show that the budget deficit will not blow out and that fiscal consolidation objectives can still be achieved. Beyond some substantial fiscal stimulus, the Sterling's best hope is that the Bank of England delivers on most of the aggressive tightening currently priced into markets. The BoE, which has been reluctant to hike rates aggressively, will need to roll up its sleeves and fight inflation with larger rate hikes.
Prolonged currency depreciation in the likes of the Euro and the Pound will add to inflationary pressures, and interest rates rising for longer, fuelling a socio-economic crisis. Without meaningful support from the respective central banks, the EUR and the GBP risk a more profound plunge. In the options market, investors are overwhelmingly bearish on the GBP-USD, with the risk reversals over 3-months and 1-year plunging to deep negative levels.
The above has major knock-on effects for Central Eastern European (CEE) currencies, which are still suffering from the effects of the Ukraine war. While gas prices will continue to impact CEE currencies, they are most vulnerable to the European Union's next steps in addressing the energy crisis. In addition, presidential elections in the Czech Republic early next year and a parliamentary election in Poland at the end of 2023 provide an environment of increased currency volatility. Furthermore, any surprises in these elections might trigger some adverse market reactions. Moreover, any shift in fiscal policy decisions might have long-term ramifications for currency and bond markets.
European stocks have taken a considerable hit following the tragic turn of events in Ukraine, and the developments that have followed as global supply chain disruptions caused by the war amplified existing concerns over the impact of inflation, rising interest rates, and fragile economic growth prospects. While investors are pinning their hopes on a year-end rally on earnings resilience, estimates remain relatively high, despite sharp revisions in forward earnings throughout Q3. Adding the risk of further social unrest to the mix suggests that European equity markets remain in a delicate position. A certain degree of this risk is priced in, but the narrative is that the European major's sell-off will be prolonged and painful. The exodus from global stock markets remains concerning, given the level of conviction that central banks continue to exude. There are few asset classes to hide in, other than perhaps money markets, but they are negative in real terms.
Europe's Stoxx 600 Index recently joined US and regional peers in a bear market as fears of a looming recession hammered demand for risk assets. Total declines from a January record high are now 20%, with the index trading around its lowest level since December 2020. Despite outperforming global markets this year, European equities may continue to trade at a discount to their global peers. The chart on the left shows the discount European stocks are trading at against the S&P 500, the largest since at least 2005.
As we head into the year's final quarter, we should expect a tug-of-war between valuations and news flow. However, given the uncertainties around the geopolitical landscape and the potential for social unrest, even these attractive valuations may not be enough to entice traders to jump in. As such, a deeper rerate is looking increasingly more probable for the Euro Stoxx.
Bottom Line: Social unrest has become a significant concern for financial market participants in recent years due to economic and financial consequences and policy changes that may influence economic development in the long run, with implications for financial market performance. Since the outbreak of the war, various asset classes across Europe have suffered a bloody nose and are still bleeding amid the current cost-of-living crisis and political developments. The current energy crisis is not only wreaking havoc on the continent's economy but could also breed political consequences, social unrest, and rising populism. Strong populism across Europe will tear apart the EU's unity and disrupt ties between Brussels and Washington. Given that the EU has been hit hard by a two-year COVID-19 lockdown and now the worst energy crisis in decades, it may be too fragile to take the blow of rising populism, which risks policy missteps and a deeper recession. The key takeaway is that Europe's challenges are also noticeable on other continents and carry a similar concern for economic growth, financial and political instability, and upheaval.