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Politics —- populism in the Eurozone? Few predicted that the UK would vote to leave the EU and Donald Trump would win the US presidential election in 2016, least of all pollsters (and many in markets). As Michael Hartnett argues, the rise of populism can be linked to what he refers to as Peak Inequality and Peak Globalisation. Trump and the Brexit campaign tapped into deep apathy with the socio-economic order that for them remains unreformed post-GFC. That’s why the poster boy for this dislocation is often the blue collar voter whose standards of living have not been rising in the increasingly globalised world. The crucial question for investors as we enter a busy year for European politics (see table opposite} is whether the populism train will gather pace or terminate at the Eurozone. Italy risks elevated, but risks two way and banks the bigger issue Although Italy goes to the polls this year, it is worthwhile starting with this Sunday’s vote. In Strategy Insights: Italy risks elevated we argue that our base case is a narrow rejection of the proposed constitutional reform, which is another vote against governing party on Dec 4. But unlike UK/ US, this would be expected and Renzi is likely to stay on so the outcome should not carry the same surprise or uncertainty factor for markets. The tail risk are also two way. A large “No” vote could perceived as supportive of the 5 star Movement but a “Yes” vote would be bullish Italy and risk assets more generally. The bigger issue is likely recapitalisation of the Italian banks. This remains a significant tail risk for banks and was part of why we downgraded the sector. A Le Pen victory could prove the biggest risk to European markets in 2017 Probably the most natural fit for the populism theme in 2017 is the French presidential election. Although polls have been somewhat discredited by events this year they remain useful as an indication of where the public mood lies. With that caveat in mind, current voting intentions suggests Front National leader Marine Le Pen will receive enough votes to progress to the second round and is likely to be joined by Republican candidate Francois Fillon. Although when Fillon and Le Pen are polled together in a second round runoff Fillon is ahead by ~65%-35%, Le Pen is seen as capable of appealing to the same anti-establishment / blue collar voters as Trump/ Brexit. Chart 37: Vol already picking up around the French primaries next year Chart 38: Yet Fillon still well ahead of Le Pen in polls of a potential run- 6 off 25.5 100 25 90 80 24.5 70 24 60 23.5 50 23 40 30 22.5 70 22 10 015 m—— VSTOXX 11/29/2016 9 ———=VSTOXX -1m a v4 12-14 15-17 13-16 10-12 14-17 9-11 25-Nov 27-Nov KS) A A A A A A April April May June June Sept o o o G io o WY fF FF KF EK KM SK SY m Francois Fillon (%) Marine Le Pen (%) Source: Bloomberg Source: Ifop (12-14 Apr, 14-17 Jun), BVA (15-17 Apr, 13-16 Mar, 10-12 Jun, 9-11 Sept), Odoxa (25 Nov), Harris Interactive (27 Nov). Note: all 2016. Investors’ biggest concerns are that we could see the same narrowing of polls in favour of Le Pen into the election months as we saw in the UK/US. We think this could mean French political risk becomes a major overhang for European equities in H1 2017. The worry is that a Le Pen Presidency could bring the future of the EU and the Euro into question as she has talked about France withdrawing from both and is especially an issue because of the winner takes it all nature of French presidential elections. As James , Bankof America 16 European Equity Strategy | 01 December 2016 Merrill Lynch HOUSE_OVERSIGHT_014475