Emmanuel Macron might have wished for a better backdrop against which to lay out his vision for the EU. In his 26th September speech at the Sorbonne, Macron painted a stridently optimistic, cohesive picture of the future of the Union, saying that he wanted to ‘give Europe back to its citizens.’ He claimed that only a more fully integrated Europe would push back the tides of nationalism currently sweeping the continent. Amongst his proposals were pan-European universities, a European monetary fund, even a trans-European military response force
One line was particularly piquant: ‘I don’t have red lines, I only have horizons,’ he said, a direct challenge to the German FDP, likely to form a coalition with Angela Merkel’s Christian Democrats in the coming weeks. The leader of the FDP, Christian Lindner, is notoriously sceptical of the European project and spoke of ‘red lines’ that should not be crossed by Germany, particularly when it comes to providing financial support to weaker Southern European states. It’s striking that Greece’s Banking Sector Index (ASEDTR) fell 18% in the three days after the German elections1, a reflection of fears about the continuation of German support for peripheral nations. With a far-right party about to take up seats in the Bundestag – and AfD are, as one would expect, trenchantly anti-EU – it’s been a rough few weeks for a Europhile.
While Greek stocks have taken the worst pummelling in the wake of the German elections, it may be that another country – Italy – presents the EU with near-term challenges too. The country continues to stagnate economically, while referendums in Lombardy and Veneto – two of the wealthiest states in the country – could further strain an already fragile political system. The results of the referenda will not be legally binding, but the plebiscites have been driven by the perception that the north is being asked to pay too high a price to support the chronically underperforming south. There are general elections on the horizon in Italy, with considerable uncertainty surrounding any potential outcome. It’s worth noting, though, that Italy’s stock market is yet to follow Greece downwards.
Does all this change our optimistic position of Europe? Not entirely. We remain relatively sanguine – there are numerous reasons that Europe should be rallying just now, from a large number of positive economic signals to the possibility of a surge in M&A and buyback activity. But with the Stoxx Europe 600 initially down as much as 8% from its peak since the election of Macron, and now down around 3%2, and with further headwinds provided by the surprising outcome of the German election, we recognise that there are reasons that Europe hasn’t been rallying with the same enthusiasm as the US and Asia.
There’s a salutary comparison to be made between Europe and Asia just now. Asia is enjoying a structural bull market. This means that both currencies and stock markets are rising in tandem, evincing genuine investor support for the growth-driven story currently playing out. In Europe, it’s rather different. What we’re seeing is an inverse relationship between currency and stocks, so that even though the euro has rallied significantly in recent months, the stock markets have been moving in a quite different direction. It’s reminiscent of an Asian market in the not-so-distant past – Japan. Europe is currently sending out strongly deflationary messages. Any systemic weakness is felt first and most profoundly in Europe, just witness the recent North Korean missile tests. You’d expect Asian stocks to have born the brunt of any selling, but it was in fact Europe that was hit, another clear sign of deflationary pressures at work in our view. This says to us that any talk of the ECB following the Fed in tapering its stimulus programmes may be dangerously precipitous.
Figure 1 shows the relative performance of the Stoxx Europe 600 against the MSCI World Index since the creation of the euro. What this demonstrates is that Macron’s presidency, far from being welcomed by the markets (the general narrative at the time), has actually been the catalyst for new (relative) lows. If Macron is increasingly to be the voice of the European project, stepping into Merkel’s shoes while the Chancellor attempts to build a coalition (and don’t rule out another election in Germany), then it’s worth looking more closely at the markets’ markedly negative response to the French President.
Figure 1. Relative performance of Stoxx Europe 600 versus MSCI World Index
Source: Bloomberg, as of 27 September 2017.
We see it as positive that Macron has staked so much early political capital on reforming the labour laws and simplifying France’s ponderous Code du Travail. The reforms have gone fairly smoothly so far and it looks to us as if Macron really means it when he says he’s ‘turning the page on three decades of inefficiency’. Importantly, there has been relatively muted protest to these moves, although you can never rule out riots on the streets of Paris. The lack of popular uprising may be a sign that the moves haven’t gone far enough, but it should also be remembered that the far-left in France is fragmented and riven by infighting, the trades unions currently alienated from their traditional political allies, the Socialist and the Communist parties. It may finally be that the cliché of French bureaucratic ineffectiveness is laid to rest.
This again begs the question – why does such a positive political backdrop feed through only to the currency and not to the French equity market? If we drill down deeper into the French economy, we can see that much of the positive economic news of recent years has been driven by the rapid expansion of the public sector. In our view, this is effectively debt-fuelled growth, unsustainable in the long term. Figure 2 gives an idea of how far France has to go to catch up with the productivity of her German neighbour. While Macron’s moves are certainly welcome, there’s a long road ahead and fixing the labour laws is only one step in solving France’s competitiveness conundrum.
Figure 2. France’s private sector stagnation and public sector boom
Source: Gavekal data and Macrobond, September 2017.
None of this, though, changes our basic stance on Europe. We do not believe that the very existence of the euro will be at risk in the near future, and we think the prospects for the area are better than share prices currently suggest. The economist Charles Gave said in a recent research note that ‘the French and the German economies are inexorably diverging and will continue to do so as long as the euro exists’. We are not quite so pessimistic, but we do feel it is clear that the outcome of the German elections has made convergence between the EU’s disparate component states less likely. And while the FDP have praised Macron for his reformist agenda, the prospect of closer ties between France and Germany, at least in the near term, seems unlikely in our view. Supportive technical and cyclical factors remain in play, but it feels like, for the near term at least, politics could continue to be the main driver of European share price action, and Emmanuel Macron’s optimistic vision of a thriving, borderless, integrated Europe may remain tantalisingly out of reach.