26 September 2017

Despite Europe’s recent economic upswing, Germany’s election result provides a stark reminder of the region’s political discontent in the aftermath of the Euro crisis, protracted unemployment, and increasing income inequality.   Following the disappointing elections, can Chancellor Merkel and French President Macron produce the domestic and EU reforms needed to produce European prosperity? Despite UK Prime Minister Theresa May’s more pragmatic approach towards Brexit, will the German elections influence the outcome of these negotiations? What are the strategic implications?

Lancaster House to Florence: UK Policy Shift Reflects PM May’s Vulnerability

In her January Lancaster House speech, UK Prime Minister Theresa May — riding high in opinion polls — confidently laid out her priorities for the United Kingdom post-Brexit.  In addition to outlining her wish for constructive UK-EU future collaboration, she took the opportunity to warn EU partners of what they had to lose if negotiations did not go well.  And, she highlighted famously that “no deal was better than a bad deal” – that is, the UK was willing to walk away from the talks if the EU was not prepared to compromise.

Since those halcyon days, however, Prime Minister May’s political fortunes have waned.   The Conservative Party’s loss of its outright majority in the June election not only has severely diminished her political authority domestically, but has weakened also the UK’s negotiating position with its European partners. Given the altered political dynamics, Ms May struck a more conciliatory tone in last week’s speech in Florence. Here were both some positive and negative takeaways:

• On the positive side, the Prime Minister’s more pragmatic approach conceded several positions we suggested would be necessary in our earlier blog “Brexit: The Clock is Ticking, Loudly”.  Most importantly, she acknowledged the impossibility of formalising a new trading regime with the EU prior to the March 2019 deadline. This was obvious to us from the outset, but finally she has given in to the inevitable. The decision to maintain the current trade and financial relationship temporarily after leaving the European Union is the simplest and cleanest option available, and should be commended.
• Also, without completely giving away the UK’s negotiating strategy, she has abandoned virtually the “no deal” option. She has eliminated the possibility of a “cliff edge” in 2019 (although the possibility still exists in 2021), which should improve business confidence.
• I suspect the Bank of England will breathe a collective sigh of relief over the Prime Minister’s pragmatism. More resilient business confidence will give the central bank more flexibility regarding interest rate normalisation in coming months, especially reversing the interest rate cut adopted in the immediate aftermath of the last year’s referendum.
• Despite these favourable attributes, however, the speech revealed also many worrisome aspects. Perhaps most importantly, even at this late stage, the UK does not have a clear vision of life post-Brexit, and the Prime Minister lacks the political authority to pursue this goal even if it existed. We hear repeatedly that the UK does not want a deal like those of Norway, Switzerland or Canada.  However, we have heard precious little of what the government is looking to achieve (much to the frustration of RU negotiators).  Moreover, Prime Minister May has shown a tendency to be easily blown off course both by public opinion or heavy-weight political colleagues/adversaries.  To be sure, this is not too surprising.  Ms May initially campaigned to remain in the EU.  After the referendum and her selection as Tory leader, however, she was persuaded by Tory hardliners to adopt a strident approach to Brexit negotiations.  Now, reflecting her weakened authority following her own poor performance during the June campaign and election, she has shifted again towards the more conciliatory stance revealed in the Florence speech.  The UK lacks effective political leadership during this vital period.
• Even though I agree with the decision to adopt the two year post-Brexit transition period, I still believe this is unlikely to provide enough time to negotiate a bespoke bilateral trade deal. The two year deadline is a concession to Cabinet hardliners, e.g. Liam Fox and Boris Johnson. It reflects also the desire to conclude the new trade deal prior to the next general election. While some believe the Prime Minister is showing flexibility, the timescale reveals also her political vulnerability – she is forced to make political concessions to the likes of Boris Johnson rather than admonishing (sacking) him for his lack of loyalty.
• I suspect the Prime Minister has built enough of a consensus within her cabinet to survive through March 2019. Once she can assert that she has fulfilled her pledge to leave the EU, I believe the Tories will seek new leadership in order to finalise the new trade agreement.
• In the near term, the UK does not appear to have made enough progress on the three initial issues (Ireland, citizens’ rights, and divorce bill) to begin trade negotiation in October. While the Prime Minister did make constructive comments on two of these topics, Ireland remains the toughest issue (see my blog on the role Irish farmers may play in the Brexit saga).  December now appears the most likely date for the initiation of trade negotiations.

German Elections: EU Reforms Needed Urgently

The German election result was both surprising and disappointing.  However, in order to understand the implications for economic policy and financial markets, it is important to put the outcome in a wider context. In Germany, the collapse in support for the established parties — the SDP (especially) and the CDU – was mirrored in elections earlier this year in both France and the Netherlands.  Indeed, despite French President Macron’s eventual landslide victory, the National Front emerged as the second largest party, and both the traditional Gaullist and Socialist movements were decimated.  In the Netherlands, likewise, the share of the vote for the ruling VVD and the Labour Party declined 25%, and Geert Wilders’ populist PVV emerged as the third largest party.

The demise of these traditional parties and the growing appeal of populist, far-right, extremist alternatives reflect the growing, widespread doubts within Europe that the established institutions can provide the solutions for weak economic growth, high unemployment, low productivity, and declining real wages. In such an environment, the rise in anti-immigrant sentiment is not too surprising.  As a result of rising inequality, much of Europe’s electorate doubts now whether the benefits of globalisation have been widely shared.  The European Union – perceived by many as inflexible, bureaucratic, and elitist — has been a focal point for these popular misgivings.

Following President Macron’s victory, we warned that the appeal of populist/extremist parties would return unless Europe’s national governments and the European Union could implement the reforms needed to boost employment and economic growth (see my blog “Mr Macron: Europe Needs You to Succeed”). This is even truer following the German election result.

The consensus will focus on the obvious setback for Chancellor Merkel; thereby, making EU reform less likely. In time (not long I suspect), however, I believe the German election result will be yet another wake up call for the European Union.  I believe the entire German political establishment and the vast majority of the electorate are shocked (appalled) by the result.  After a Premiership focused on steering Europe through its most serious economic collapse and responding admirably to the Syrian humanitarian crisis, Chancellor Merkel will not want to be remembered for this election result, and the rise of German nationalism.  I expect all the traditional parties to seek to isolate and minimise the influence of the AFD. In this environment, frankly, the SDP’s decision not to participate in a continued Grand Coalition is disappointing.  At this stage, a CDU, FDP, Green (Jamaican) coalition appears most likely.

Implementing EU reforms is difficult in the best of times.  Germany and France do not always agree on key topics such as debt mutualisation and the need for a German-led expansion in European fiscal policy.  Indeed, the inclusion of the conservative (tight-fisted) Free Democrats in Germany’s likely coalition will make agreement potentially more difficult.  However, with Chancellor Merkel wanting to preserve her legacy and President Macron wanting to build his, perhaps this is the moment Europe will finally grab.

There is a Brexit link in this saga. European leaders – especially Macron and Merkel – will want to demonstrate that EU reforms are possible, and life within the Union is preferable to life outside.  In this light, the United Kingdom will face even greater European resistance to any bilateral agreement perceived as British “cherry picking” – seeking to gain the advantages of EU collaboration without accepting its costs and responsibilities.

Strategic Implications  

• As outlined in my blog “The Next 6 Months are Vital for the Trump Presidency”, I still favour European stocks over the USA. Accelerating growth, low inflation, a weaker USD, and easy ECB monetary conditions provide support.  While the German election result complicates timing, I expect a greater urgency towards European reform to emerge eventually.
• During the next 6 months, the USD will appreciate. The US Fed will tighten and reduce its balance sheet.  The Trump Administration will deliver some tax reform and fiscal expansion.
• The UK economy and stock market will underperform those on the Continent.
• Brexit logjams will produce UK sterling weakness near term, despite the increased likelihood of tighter BOE policy. Eventually, GBP/$ will reach 1.45, but will first approach 1.25.