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"Political populism will ultimately make the European Union (EU) assets pay the price. The euro is showing weakness against the strong dollar and may stay below parity (1 euro = 1 dollar) for 1 to 2 years."

David Roche, a global investment strategist and chairman of Independent Strategy, likened the recent sharply increased political risk in Europe to a "doughnut with a hole," diagnosing that the economic impact will be inevitable.

In a written interview with Asia Economy on the 25th, Roche said, "The biggest risk in Europe at this point is political populism and paralysis at the EU level." A renowned investment strategist formerly of Morgan Stanley, he was among the first on Wall Street to warn of the 1997 Asian financial crisis including Korea, and to predict developments such as the 2008 global financial crisis. This is Roche’s first interview with domestic media.

David Roche, Chairman of Independent Strategy
[Image courtesy of David Roche]

First, Roche commented on the European Parliament elections earlier this month, where the far-right forces made notable gains, saying, "The political influence of (far-right parties) in the parliament may be limited, but the national-level results in countries like France and Germany were bad," adding, "The black hole of the early French general election empowering extremists and political paralysis in Germany will undermine the stability of the EU Commission."

He defined this political landscape in Europe as a "doughnut," not a "souffl? (a puffed French bread)." He also said, "The public has moved to the edges of democracy, and the weakening support for the center is not new," diagnosing that "especially French President Emmanuel Macron, who announced an early general election right after the European Parliament election, has created a 'huge black hole' in the middle (of the bread)." He warned, "This has important implications for the whole of Europe," and "this hole will be filled by extremists."

The upcoming French general election is cited as a clear example of the recently highlighted political risks within Europe. Roche predicted that in the elections held on June 30 and July 7, "The far-right party led by Marine Le Pen (Rassemblement National, RN) will win," and "constructive cohabitation between President Macron and a far-right prime minister will be difficult. Political paralysis in France will be confirmed." He added, "Extremist groups, whether left or right, will compete to spend money recklessly, ignoring EU-level stability and growth pacts and fiscal discipline procedures," forecasting that "there is more than a 50% chance that France will not comply with EU debt rules." With public debt already excessive, populist policies that pour money indiscriminately are rampant, and progress on EU-level policies will become even more difficult.

This political turmoil is expected to spread to the markets as well. Roche projected that the yield spread (10-year) between French government bonds and the safe-haven German bonds will widen from the recent 70 basis points (1bp = 0.01 percentage points) to double that. This indicates increased investor anxiety about France’s fiscal and economic situation and greater fiscal burdens such as debt interest. He also warned that if the European Central Bank (ECB) intervenes with the Transmission Protection Instrument (TPI), a bond-buying program to prevent sharp rises in specific countries’ bond yields, "the euro will pay the price for the loss of ECB’s credibility, and other EU member states’ assets will also be affected." Already, in France, the stock market has plunged and bond yield volatility has increased since the early election announcement.

[Image source=Reuters Yonhap News]

The situation in Germany, another major EU country closely watching the French general election, is equally unstable. Roche noted that in the recent European Parliament election, the ruling party in Germany was overtaken by the far-right party Alternative for Germany (AfD), predicting that "German Chancellor Olaf Scholz will soon step down." He pointed out, "Although the situations in France and Germany differ, the political problems causing them are the same," adding, "The center is shifting to the extremes, and established parties have not come up with answers on how to respond to the spread of populism." He lamented that seven reforms are needed to prevent the EU’s decline, including EU enlargement involving Ukraine, NATO supplementation, and strengthening European defense capabilities, but these are also not easy.

Roche emphasized that this political situation in Europe "is important to everyone but especially significant for investors," pointing out that "there will be a common victim called economic growth." In the immediate political turmoil, German bonds are expected to be recognized as safe assets and converge to U.S. Treasury yields. However, he explained that "ultimately, EU assets will pay the price."

In particular, Roche predicted that "to prevent the impact of Europe’s political turmoil on financial markets, the ECB will use all means including the TPI, and the euro will become the ‘scapegoat.’" He said, "The U.S. dollar will continue to strengthen, and the euro will be devalued below parity, maintaining that level for 1 to 2 years." The euro is currently around $1.06 amid the ECB’s recent rate cuts widening the interest rate gap with the U.S. and the emergence of political risks from Europe. Roche currently expects the ECB to cut rates by an additional 0.25 percentage points within the year.

The outlook for European stock markets is also negative. Roche said, "Although recent European stock market performance has been good, it is unsustainable and will underperform compared to the U.S. stock market," adding, "We know we will recover when the U.S. stock market bubble bursts, but Europe will not." The pan-European stock index Stoxx Europe 600 was up about 5% year-to-date as of the interview date. Roche’s team is currently reducing their European equity exposure.

Additionally, Roche warned of geopolitical risks including the Russia-Ukraine war. He said, "The risk in the Russia-Ukraine war is that Russia breaks through Ukraine’s defensive lines in the northern Kharkiv and Sumy regions, breaking the current war of attrition," diagnosing that "in this case, the possibility of Ukraine’s defeat increases and dangerous situations could unfold in Europe." He added, "This would lead China to believe it can win a (military) war in Taiwan," and "it will escalate risks globally."