Portuguese Politics Morphs into Technocrat Choice

The debt crisis in Europe is having political ramifications. Ireland elected a new government earlier this year and Portugal will do so this weekend. The latest polls suggest the most likely outcome is a coalition government between the Social Democrats and the People's Party.

The crisis renders party platforms nearly irrelevant. The terms of the recent aid package are generally agreed upon. That is the agenda. It is a 3-year plan to cut the deficit through a combination of spending cuts, tax increases and privatization. The deficit is projected to fall from almost 6% this year to 3% in 2013.

Nor is the personality of the leading candidates very important. For investors, there is one key issue and that is the strength of the government. Will it have sufficient authority to implement the painful austerity? Therefore the larger the majority of the coalition government the better the market reaction.

The end of the Cold War arguably narrowed the differences between leading parties in Western democracies. The financial crisis is doing something similar It is dictating the agenda in the periphery and may shape next year's elections in Germany, France and Spain.

The risk is that the austerity agenda is going to lead to chronic political instability in the periphery. Incumbents who enforce austerity get voted out of office. New people get elected and they enforce austerity and they too get voted out of office. If governments could deliver growth and austerity, the situation would be different. The outgoing Portuguese government recent revised lower its forecast for growth to a 2% contraction, which is twice the size of the contraction of the previous guesstimate.

Prime Minister Socrates drank from a poisoned chalice. The next government, to be chosen this weekend will drink the same hemlock. It is a deadly serious cocktail because ultimately Portugal's root problem was not fiscal excesses, but an uncompetitive economy and private sector debt is much greater than the government's debt burden. Public sector reforms may be part of the solution, but is hardly a panacea and in fact, it alone may exacerbate Portugal's economic woes.

There is unlikely to be a dramatic market reaction to the Portuguese election results. The news stream from Greece is seen as more important. Portuguese bonds have sold off hard in the run up to the election. The 10-year yield rise of 25 bp over the past week is the most with in Europe. Getting past the event risk and the long-end may play a bit of catch up.

In terms of the euro, the ECB's press conference next Thursday is far more important. We expect the Trichet to signal a rate hike in July. With today's gains, the euro has recouped almost 2/3 of the decline in suffered in early May. Confidence that the euro is headed back to the $1.4950-$1.5000 area should be lifted by the price action and reinforced by the divergent monetary policy trajectories, as the peripheral debt crisis eases back away from the abyss.