Although populist political pressures are strong across Europe, they may not prove strong enough to break EU institutions.

In Europe, we are learning that populist opposition to the status quo is high, particularly with the examples of the recent Italian referendum and the rise of the far-right in France. But we think this opposition is not strong enough to wrest political control of these nations or the European Union; it is only strong enough to be a persistent risk and constraint on the economy. In other words, the risk of eurozone breakup is not trivial, but in the short run we think of it as a nagging headache, not a heart attack.

Austria flirts with nationalism, Italy rejects political reforms

The recent re-run of the Austrian presidential election raised the possibility of a far-right head of state in a European country for the first time since World War II. Opinion polls had suggested the race was too close to call, but Norbert Hofer, politician for Austria’s far-right Freedom Party, conceded defeat as early results came in, and looks to have lost by about six percentage points to Alexander Van der Bellen, an economist and member of Austria’s Green Party. This is the first time in a while that we have had a pre-election opinion poll error that understated the support for liberal internationalism.

The referendum result in Italy, by contrast, was a resounding rejection of Prime Minister Matteo Renzi’s proposed political reforms. The margin was large (practically 60/40), and turnout seems to have been around 70%, much higher than most analysts had expected. This combination left Prime Minister Renzi with no choice but to offer his resignation. For us, the Austrian and Italian developments signal two areas of concern: potential financial shocks that may proceed from political events like Italy’s referendum, and the broader dimensions of political risk in Europe.

Italian bank issues overshadowed by bigger political questions

Italy’s banks, which remain saddled with massive amounts of non-performing loans, are not likely to send Italy or Europe into a financial crisis, particularly with the ECB’s early-December announcement that it will extend its bond-buying support through 2017. More concerning is what happens next in Italian politics. But even there, we imagine that some form of a caretaker government will soon be tasked primarily with passing an electoral law ahead of new elections in late 2017. In the short run, this means that the economic reform agenda, which Renzi had put to one side to focus on the political reforms, will remain sidelined.

Overall, we do not see Italy’s referendum result as significantly increasing the chance that the next election will bring a populist, anti-Euro government to power. In particular, we do not believe that the current Italian Parliament will write electoral rules that will allow the populist Five Star party to gain enough seats to form a government on its own. Electorally, the populist vote is split between the left and the right with no unifying figure in sight and little chance of securing a Parliamentary majority.

In France, populism may be held at bay

There are oddly similar dynamics at work in France. Former Prime Minister François Fillon won the conservative primary, beating both former President Nikolas Sarkozy and former PM Alain Juppé. Fillon is more socially conservative than his rivals, but he also has been arguing for more authority to be returned to national governments from the European Union, and he has announced an aggressive set of economic-reform proposals.

On current polling, the two candidates most likely to advance to the second round of French elections are Fillon and far-right Front National leader Marine Le Pen. A variety of political observers seem confident that Fillon would win a contest with Le Pen quite handily. If this is correct, in 2017 we would see France elect a president with a clear economic reform agenda. On the other hand, President François Hollande’s decision not to run for reelection, given his low levels of popularity, opens up the possibility that there may be a compelling candidate from the left, and this could change the race’s dynamics.

Meanwhile, we think Le Pen’s chances of pulling off a Brexit- or Trump-style upset are small. Even when she is polling well, she does not appear to earn a majority of votes in the second round. Of course, the polls could be wrong, and Le Pen could end up drawing votes unexpectedly in the way Trump did in the Midwestern United States. On the whole, however, market pricing suggests that there will be no major shock from France next spring.

Social exclusion is rising in the eurozone

A defeat for Front National would not be a signal that Europe’s populist wave has been reversed or halted, however. Indeed, there are reasons for thinking that the eurozone’s socioeconomic developments are worrying. Recent Eurostat data on “social exclusion” — a concept the EU uses to measure vulnerable populations, including the poor, the unemployed, and people who would be in poverty if not for government payments — show social exclusion on the rise. While we might expect to see this in Europe’s periphery, it is also true in some countries in Europe’s core.

It is also fairly clear to us that the trends are different in the eurozone than in the rest of the EU; in other words, there is something about the eurozone that is making economic outcomes worse than in the obvious comparator countries. That “something,” we would contend, is the policy framework, which lacks flexibility. This is why the populist movement in Europe is gaining ground and why it names “Brussels” and “globalization” as specific enemies.

Despite populist pressure, European institutions remain robust

In our view, European adherence to the current policy regime will continue to stifle economic performance and raise political risks. In the short run, however, we think it will remain hard to make money from betting against the resilience of European institutions. (Remember the drama over Greece?) European political systems have a way of opting for outcomes that preserve the status quo, even if they are suboptimal economically. Importantly, that is why populist pressure is not likely to disappear.

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