"The consequences of a bad outcome may be severe."
Some would call that an understatement. Marco Valli, the chief euro-area economist at UniCredit SpA in Milan, was reflecting on the chances of an upset in one of this year's three major elections in Europe.
The votes hold the real -- albeit unlikely -- prospect of installing at least one leader devoted to dragging her country out of both the single currency and the European Union. In the shadow of surprise victories for Donald Trump and the campaign for Britain to leave the EU, that's throwing up a raft of new challenges for investors.
It also creates a risk that, in their efforts to avoid being caught off guard by another "Brexit" or surprise electoral win, investors are dwelling too much on political events and ignoring a host of regional economic data that has shown some signs of recovery. Figures released Monday, for instance, showed monthly German factory orders surging by the most in two-and-a-half years. The DAX fell 1.2 per cent that day as European stocks sold off.
"The case for investing in euro zone assets has never been harder to make," Alberto Gallo, head of macro strategies at Algebris Investments, wrote in a note to clients. "Equipped with sophisticated macro models, but sometimes lacking confidence in the EU's political intricacies, investors often decide to give up on Europe altogether. We have not."
Unfamiliar Triggers
Instead, Mr. Gallo is among those who have been picking through the vagaries of the French electoral system and the nuances of British parliamentary procedure. With French, Dutch, German and possibly Italian voters due to go to the polls in 2017, and the U.K.'s negotiations for its EU exit set to begin formally, the ins and out of central bank policy that dominated sentiment in recent years have been replaced by politics as the key driver of markets.
That may spell more volatility as investors are forced to react to relatively unfamiliar triggers. The pound has already swung wildly after seemingly innocuous developments in the U.K.'s Brexit process, while French bonds have been hit hard by the controversy over presidential candidate Francois Fillon, even though polls show that his opponent Emmanuel Macron has a better chance of defeating the anti-euro Marine le Pen.
Debt Crisis
The pound jumped Oct. 12 when Prime Minister Theresa May accepted that Parliament should be allowed a say on taking Britain out of the EU, even though observers said such a move was unlikely to water down her plans. The France-Germany 10-year yield spread climbed 10 basis points to the widest since 2012 on Monday after Mr. Fillon said he would stay in the presidential race.
The sudden moves are reminiscent of swings seen during the debt crisis, when so-called bond vigilantes used to prowl the market dispensing fiscal discipline by forcing up borrowing in countries they saw as erring from the right path.
While central bank policy had largely nullified their power, or at least shifted their focus to the currency market, speculation European Central Bank stimulus may be nearing its endgame is making the bond market more susceptible to political risks.
"It is an incredibly important trend and it's part of the broader sweeping shift in the epoch that we are actually in," said Luke Hickmore, an Edinburgh-based senior investment manager at Aberdeen Asset Management, which oversees about $374-billion. "We are at very near the end of a massive deflationary shift in the world caused by globalization, demographic change, central banks being in charge of monetary policy. If we are at the end of that, then politics become absolutely crucial as one of the key drivers of volatility for markets."
For now, the swings are not translating into all parts of the market. The difference between the CBOE Volatility Index -- a gauge of investor anxiety, commonly known as the VIX -- and the Global Economic Policy Uncertainty Index is at a record high, underscoring how global equity markets have shrugged off surging policy risks. Still, open interest in French and Italian bond futures has jumped to a record, signaling an increase in hedging.
"Political risk is now clearly the driver for euro-area markets," said UniCredit's Valli. Even with the chance of an upset in an election this year at less than 50 per cent, "the tail risk is thick," he said.