09 March 2017
Is the party about to start in Europe?
We might be leaving at just the wrong time
by Frank O’Nomics
Have you ever left a party early, only to be told that it really got going after your departure? Or, have you not returned to a play after the interval, then to discover that the second act made sense of it all? Recent European data, and possibly misplaced caution ahead of the myriad of elections, point to the prospect of the single market’s potential finally being realised. If this is the case, rather than continental Europe holding back the UK, we may finish up missing out on some significant support.
European growth has been exceeding expectations. GDP in the euro area economy grew by 1.7% in 2016 and the most recent purchasing managers index (a more forward looking indicator) jumped to 56 from 54.4 (a number above 50 indicates growth), its highest level since 2011. Interest rates are very low but look set to remain so for some time. Even though inflation has picked up to 2%, the core level remains low at 0.9% and it seems unlikely that the ECB will start to react, beyond some tempering of the level of quantitative easing, until it exceeds 1.6%. As for any actual tightening of interest rates the wait should be much longer. In short, Europe faces a very accommodative monetary policy for a long time. Austerity measures have benefited many; at least to the extent that debt to GDP ratios are improving nicely, and a weakening Euro has given a much-needed boost to competitiveness (albeit not against sterling). The problem in terms of generating any improvement in sentiment towards Europe, however, lies not with economics but with politics.
Election fears are largely misplaced. This year sees elections in France, Germany, the Netherlands, Spain and, potentially, Italy. The greatest concern in the short-term has been over France. There seems little doubt over Marie Le Pen winning in the first ballot and, while all current polls suggest that either Fillon (if he is still standing) or Macron will win in a second round, markets are still pricing in the risk of a Le Pen victory and a possible move away from the Euro. These concerns would appear to have little validity, with little prospect of a Brexit-like poll shock. Firstly, if one applies the variance surrounding the UK vote on Brexit to the French election, as analysts at Deutsche Bank have, the result does not change – a Fillon or Macron victory is assured. Secondly, there is a long history of polls showing strong support for Le Pen only to be negated by an actual ballot. Thirdly, the two round system in France makes even a divergence as extreme as that in the UK very unlikely. Finally, the income differentials in France are much lower than in the UK, which mutes one of the drivers of the Brexit vote. French bond yields have widened significantly against other core-Eurozone countries, leaving considerable scope for outperformance once the election outcome is known. There is also plenty of potential for equities to outperform, in both France and Europe as a whole, having lagged behind FTSE by 7% and the Dow Jones by 11% over the last 12 months. This has started to turn itself around, with Europe gaining 2.5% vs FTSE in just the last month. The political situation in France (along with electoral concerns elsewhere) may have been holding back European equities for quite some time, and points to an encouraging buying opportunity, for those prepared to ride some short-term volatility, ahead of the polls on 23rd April and 7th May.
If France were the only electoral banana skin to avoid, the decision as to whether to buy European assets might be clear-cut. Unfortunately there are other, more uncertain, ballots to worry about. Germany and the Netherlands may not be great worries and, while Catalan issues create some uncertainty for Spain, the Spanish economy approaches the election is very good shape with GDP growth running at 3% year on year. The biggest concern is likely to surround any move towards an election in Italy (an election has to happen by 23rd May 2018, but could come sooner). Firstly, from an economic point of view, Italy is still the poor relation in Europe, with growth stagnating and debt ratios stubbornly high. Secondly, the size of the support for parties with Eurosceptic inclinations is worryingly high. If one adds the current poll level of Five Star, to Lega Nord and Brothers of Italy one can account for 45% of the electorate, whereas their aggregate support was only 25% in 2013. This is dangerous if the other parties do not finish up leading any prospective coalition. For the cautious investor this may be sufficient to warrant continuing to avoid Europe (or at least Italy within it), but there is a big difference between supporting a Eurosceptic party and supporting leaving the Euro.
There is little to be done to stop the process of the UK leaving the EU. One of the arguments for leaving was that Europe would continue to be a drag on UK growth. A high level of electoral uncertainty is a problem for Europe – but a similar degree of uncertainty exists in the UK surrounding the terms of our departure. The UK has benefited from a high level of foreign direct investment, which was running at 72% of GDP at the end of 2015. This is far less of an issue for Europe where the level was 40.5% in Germany and 25% in Italy. For now the bigger concerns surround European politics rather than economics, but if this year’s elections can be navigated safely, we may finish up envying European growth and the performance of European assets.
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