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Investors face a European dilemma as elections loom

The European government bond market had what is known in technical circles as a minor freak-out this week.

Yet as yields in eurozone bonds diverged sharply, the markets for stocks, corporate debt and currencies carried on regardless.

The Cac 40 index of large French-listed companies was barely changed on the week. The euro weakened per cent against the US dollar, but at the same time the dollar strengthened against other weighty currencies, suggesting little fear for the future of the eurozone.

Meanwhile, the difference between the yield on benchmark French bonds and those of Germany reached its greatest extent in more than four years.

As prices move in the opposite direction to yields, the movement could be taken as a sign of investor concern coinciding with polls showing Marine Le Pen, the far right and anti-euro politician, is the most popular candidate in France’s approaching presidential election.

The contrast highlights a dilemma for investors in Europe: whether to focus on improving economic signals, or the din created by upcoming elections in France, the Netherlands and Germany, as well as a possible early return to the polls in Italy.

“All sensible analysis suggests you are going to end the year with a political situation that doesn’t look that different from where we are now, if you trust the polls,” says Charlie Diebel, head of rates for Aviva Investors.

He says French bond yields are starting to become attractive, and is making investments such as buying Polish bonds and selling the German equivalent, on the basis Bunds are expensive and prices may not reflect improving economic conditions.

Indeed, while some investors may be twice bitten, thrice shy, after a year when a majority of British voters chose Brexit, and a winning US minority elected Donald Trump, many are more relaxed.

Alex Dryden, global market strategist at JPMorgan Asset Management, says “political systems in Europe are designed in such a way that it is hard for fringe parties to push their agendas on to a country. They were created in that way on purpose after the second world war.”

Investors should look through the political clouds to focus on Europe’s economic recovery, he says.

Growth in the eurozone economy outpaced the US last year, at 1.7 per cent versus 1.6 per cent, while unemployment in the region has fallen to 9.6 per cent — the lowest level since May 2009.

“The economic recovery is pushing up cyclical stocks. Particularly consumer discretionary stocks — the things people pulled back on as unemployment rose they are going back to as jobs recover. Financial stocks are staging a comeback too as bond yields rise — eurozone bank stocks have gained over 40 per cent since last summer and we think they have further to go.”

BlackRock also announced this week it favours European equities, saying political shocks have kept investors overly cautious towards the sector, which should benefit from the global economic pick-up.

Mauro Vittorangeli, fund manager at Allianz Global Investors, says when money managers outside Europe see lurid stories about fringe politicians gaining traction they may forget it is one of the most stable economic regions in the world.

The European Central Bank’s plan to wind down bond purchases is the real reason prices across eurozone debt markets are falling, he adds, so political fretting presents opportunity.

“Brexit was a great example of this. Between the first and second round of votes in France in April and May there may be a level that we will buy at,” he says.

Yet there are some who question the underlying economic optimism.

Dhaval Joshi, European strategist for BCA, argues that within the big trends of economic movement there are smaller oscillations, what he calls six to 12-month mini-cycles which result from the interaction of bond yields, bank lending and the activity of businesses and consumers.

In this analysis the bond market had begun to turn early last year, but was interrupted by Brexit and then exaggerated by the victory for Mr Trump which has raised hopes of faster economic growth. Judged in six-month periods, slower growth in bank lending in Europe, the US and China since October presages a slowdown and lower bond yields as the mini-cycle plays out.

It may be that a fundamental acceleration in the world economy is under way, taking Europe with it. But equally, recent strength may give way to the low growth narrative of recent years. Mr Joshi’s recommendation for the next three months is to be wary of the bank-heavy equity indices of Italy and Spain.

Indeed, while many have European political risk in mind, his attention is elsewhere. “The big contributor to the upcycle we’ve had in the last 12 months is China,” he says, the result of a significant stimulus programme which has since begun to ebb. “This mini-cycle downturn does raise the question, what does China do next?”

Via FT