Markets do not have a clue how to handle political populism. They are still frightened of it, even though last year’s populist earthquakes in the UK and US are yet to have the drastic consequences that had been feared, and they cannot gauge its chances of success. This might yet create opportunities for those who can stomach some risk.
This was a great week for European stocks, which staged a rally while the Euro Stoxx 50 Volatility index, Europe’s equivalent of the Vix fear gauge, staged a huge drop on Thursday to its lowest level since inception in 1999.
What can explain this? Wednesday’s well-received announcement on interest rates by the Federal Reserve helped, as it weakened the dollar and reduced the risk of further flows into the US. But it scarcely explains the lowest level ever for European implied volatility.
Ultimately there is no choice but to put the prime responsibility on Geert Wilders, the Netherlands’ populist figurehead, who suffered surprisingly poor results in Wednesday’s Dutch election. Dutch coalition politics always meant that Mr Wilders had little to no chance of heading the government, even if he had led the largest party. The result should not be such a big deal.
But investors had braced themselves for a Willders breakthrough. According to the Predictit prediction market, on election eve he had about a 60 per cent chance of having biggest group in parliament (not the same as becoming the prime minister). His chances had in January been as high as 80 per cent.
We learnt last year that prediction markets have a problem gauging populism. They were badly wrong about the Brexit referendum. But over time they have been accurate, and they are as good a way as we have of harnessing the wisdom or otherwise of crowds.
So it is clear that Wilders’ showing was poor compared to expectation. This was a big surprise in a small country, but there was never a chance of serious disruption to the European status quo.
Yet it also moved opinion on populism’s chances in very different countries. Predictit’s estimate of the chance that Frauke Petry, the German populist flag-bearer from the Alternative für Deutschland party, becomes chancellor this year has been as high as 28 per cent. After the Dutch result it halved from 15 to 7 per cent, and is now at 11 per cent.
This sounds wildly overdone. The German proportional representation system, and the antipathy of other parties to forming an alliance with the AfD, mean she can only become chancellor if her party wins more than 50 per cent of the popular vote. That would be the blackest of swans, far eclipsing even last year’s election of Donald Trump for sheer improbability.
So her chances are overstated. But even so, the bad result for Mr Wilders in the Netherlands should not have moved the needle on her chances in the very different country of Germany. Populism is not uniform, and neither is Europe. But following last year’s two great populist victories (won by very different politicians in very different countries), there is a tendency to treat the phenomenon far too simplistically.
That brings us to the event that will likely dominate assessments of geopolitical risk until summer. In France, Marine Le Pen of the National Front looks likely to win the first round of voting for the presidency, but fall in the second run-off round against a single opponent. They still stand, even after the Dutch result, at above 25 per cent – as strong as Donald Trump appeared at the same stage last year. As she plans to leave the eurozone and then the EU, this is a significant chance of a major event. The EU would be changed utterly, and the break-up of the eurozone would pose a far greater threat to the financial system than Brexit.
But this week’s events show that market judgments of populist political risks are flawed and sweeping. From underestimating their chances last year, and setting up a historic fall in sterling, it now looks as though they are overestimating populists’ chances in the western European heartlands.
That could mean opportunity. The underperformance of European stocks compared to the US is staggering. Over the last ten years, in dollar terms, the FTSE-Eurofirst 300 has underperformed the S&P 500 by more than 50 per cent. This is mostly about valuation.
Europe should be cheaper, as it lacks the high-multiple tech groups of the US. But it now trades at 1.8 times book value, against 3.12 for the US – a gap of 1.32 times book value. Back in 2010, before the eurozone sovereign debt crisis, the gap was only 0.4 times book.
There should be a political risk premium for investing in Europe, but it looks as though investors are too scared and crude in their judgment of populism’s chances. The premium is too big, Europe looks like a buy.
If the prospect of buying makes you feel queasy, that is a sign that it offers value. But you do, of course, have to take the risk of President Le Pen.