24 April 2017

After the most unpredictable and consequential election in recent French history, Emmanuel Macron and Marion Le Pen have advanced to the second round run-off on May 7.  Even with the field now reduced to two candidates, however, the nation still faces a stark choice, as the candidates represent distinctly different visions about the direction for French society and its economy.   The consensus view is that Mr. Macron will be the next French president (I agree).   However, he will face enormous challenges in implementing the reforms France sorely needs.

The reduction in European political risk, combined with low inflation, an accelerating cyclical recovery, accommodative monetary conditions, and discounted valuations suggest European equities will outperform in the coming year.

What have we learned from the vote?

Most importantly, should Mr Macron become the next President, the existential risk confronting the European Union will have declined dramatically, at least for now.  Even this September’s German election, as important as it will be, is highly unlikely to pose a similar risk, as the major parties would create a Grand Coalition if necessary to preserve the European project.

Secondly, the result of the first round of the election highlights the deep divisions within the French electorate and society, which will not be easily mended.  The collapse in support of the Socialist and Republican movements illustrates the total rejection of the traditional political establishment.  It is still not obvious what will take its place.  This will complicate life for the next resident of the Elysee Palace.

Despite his role in the Hollande government, Mr Macron has projected himself the non-establishment candidate (Madame Le Pen will seek to exploit his role in unpopular reforms as Economics Minister). Indeed, much of his appeal has stemmed from the perception that he represents a new political direction, and he has already pledged that he would bring in many new faces into his government.  As appealing as that sounds, with the established parties in disarray, he is likely to struggle to form the political coalitions required to tackle the pressing issues he will inherit.  Indeed, US President Trump has discovered the difficulties political outsiders confront.  In France, like the USA, strong vested interest and institutional divisions make the political “swamp” difficult to drain.

Furthermore, Mr Macron will inherit serious economic challenges in a nation without a consensus on how they should be addressed.  Bear in mind, the unpopularity of President Holland’s government resulted from being too “socialist” during the financial crisis and too austere in its aftermath.  In addition to the very difficult issues of security and national identity, Mr Macron will confront:

• Government debt: Public sector debt is approaching 100% of GDP, and will continue to rise for the foreseeable without further policy changes (even Italy’s debt dynamics are on a more stable footing).  Overly generous spending is the culprit.  Despite unpopular earlier reforms, government outlays as a percent of GDP are the highest in Europe (except Finland), and continue to rise.
• Structural unemployment: Weak growth and persistently high unemployment lie at the heart of France’s political crisis.  Despite the economic recovery, the unemployment rate remains near 10%.  The jobless total exceeds 3 million, and over 2 million people are long term unemployed (over 1 year) – twice the pre-crisis level.  Joblessness is especially acute among the young, unskilled, and immigrant populations (around 20%). The IMF highlight several contributing factors, which need addressing:  Skills mismatch, excessive real wage growth, weak productivity gains, high labour market taxes, inflexible hiring/firing regulations, generous unemployment benefits, etc.  Reform will be unpopular.  Mr Macron, encouragingly and rather ironically, has his name attached to the 2015 reform package.
• Poor competitiveness: French labour costs are amongst the highest in Europe only exceeded by Nordic countries.  This reflects both high wage growth and high labour market taxation.

European Equities to Outperform

Despite the inevitable challenges that will confront the new French President, the reduction in existential political risk supports our view that European equities will outperform in 2017.

• The cyclical recovery in the European economy continues to strengthen. The Markit Eurozone PMI hit a 6 year hit in April.  The recovery in increasingly broad based.  The manufacturing sector continues to benefit from the weak Euro.  And service sector output, boosted by improving labour market conditions, is also at a six year high.  Likewise, geographically the recovery is widening.  While Germany still leads the way, output in the peripheral countries is at its high level since July 2007.
• European inflation had been rising during the past year. However, the decline in price growth in March revealed that much of the previous gains were caused by higher energy prices.  Eurozone core inflation is steady around 1%, and even lower in many key nations, e.g. France.
• With core inflation well controlled, the ECB will maintain its current accommodative stance for the foreseeable future. While discussions about when to taper its bond purchases will no doubt begin towards the end of this year, interest rates are likely to remain at the current low levels until the end of 2018.
• Of course, European markets always trade at lower valuations compared to their US peers. However, the discount of 15% is somewhat greater than usual.  Furthermore, reflecting its more recent economic recovery, European earnings revisions are picking up at a more robust rate than in the USA.
• As a health warning, despite the reduction in political risk associated with the first round of the French election, Europe still confronts formidable economic and political challenges. Following the sense of urgency during the financial crises, European reforms have stalled in recent years.  Even Brexit (to David Cameron’s demise) and the rise of nationalist sentiment in France and throughout the continent, have not inspired EU policymakers to improve transparency and accountability.  This is disappointing.  Without sustained reforms on a  unified banking system and capital market, labour market flexibility, improved productivity and competiveness, political integration, and the impact of the aging population , the European project’s future –and the Euro’s – is still not secured.  Let’s hope it does not take another economic or political crisis to get back on track.  I’m not sure.  So buy European equities, but keep in touch.