Things normally go in threes
After two political earthquakes in 2016 -the UK vote in favour of Brexit and Donald Trump's election- the third event looked like being Marine Le Pen’s victory in France’s presidential elections, coupled with a fresh eurozone crisis of very serious proportions. Recent upsets in French politics seem to share many features with last year’s UK and US surprises: François Hollande was unable to stand for a second term, leading lights of mainstream parties like Nicolas Sarkozy, Alain Juppé and Manuel Valls were eliminated from the presidential contest, Jean-Luc Mélenchon’s spectacular breakthrough seemed to echo Bernie Sanders’ performance in the US Democratic primaries and the heads of the usual government parties fell. And now the French far right is through to the second round and nobody is surprised.
For some idea of what might happen next, we should look to two other key elections in Europe in the last 6 months. Last December’s Austrian elections saw the far-right FPÖ fail to win the presidency while in the Netherlands Geert Wilders’ PVV only made limited gains in March’s parliamentary elections. True, France’s Front National (FN) increased its votes in the first round but its share of the vote was down on the first round of the local and European elections in 2014 and 2015. And the leading political factions which failed to make it to the second round all immediately called on voters to defeat Marine Le Pen, making Emmanuel Macron the big favourite to win the May 7 play-off.
Marine Le Pen is likely to be defeated but, even so, it is still too early to list the consequences from Emmanuel Macron’s probable victory. First, the future government’s exact programme will only be known once this June’s parliamentary elections are over. And those elections look like being particularly difficult to call. Nonetheless, the chances of France engaging in a reform programme have improved significantly. And the prospect of Emmanuel Macron being elected suggests relations between France and Germany will improve and the eurozone will emerge reinforced. That could keep the clean-up of the zone’s banking sector on track and result in economic policies adapted to its specific needs.
Macroeconomics rather than "macronomics"
The first-round results suggest the anti-European candidate will not win. Her defeat would really clear the political air in Europe as Germany’s elections are risk-free, judging from the opinion polls. Italy’s parliamentary elections in 2018 will probably spark some market turbulence but not before the end of this year. We will be closely watching the second round of France’s presidential campaign for any event that could weigh on the result but it is already time to refocus on the eurozone’s particularly appealing fundamentals. The latest PMI hit a 7-year high, a sign that growth is in line with our positive scenario (and still gaining traction), monetary policy remains at the same accommodating levels and 2017 earnings are being revised higher.
The European recovery is still intact and the latest surveys suggest growth could come in around 3%. It is striking to see that the IFO survey, which is closely correlated with Germany’s GDP growth, has revisited previous peaks. The two biggest laggards, France and Italy, were seeing little growth up to the autumn of 2016 but have now caught up with the others. Unlike last year when the economic upturn was still to show up in company earnings, profits are now up sharply. But although the European recovery has been taking shape for months, there have been net outflows from European equities since February 2016 when investors first started to take Brexit risks seriously.
Towards a reduction in France's discount
Markets heaved a huge sigh of relief when the first-round results for France's presidential election were announced. The euro gained ground against all other currencies while traditional safe havens like the Swiss franc and Yen retreated. Sovereign bond yields in top-rated countries edged higher. Credit spreads tightened and eurozone stock markets ended the day sharply higher. We still see room for further narrowing in OAT/Bund spreads but mostly on the back of an upward trend in core country yields. We prefer subordinated financials and convertible bonds.
Also note that implicit volatility on European equity markets has fallen significantly. In coming weeks, we expect to see investors, especially non-residents, return to European equity markets. The trend should be particularly beneficial for France which is clearly the market a global equity portfolio should focus on.
Our upbeat scenario for French equities in 2017 is based on performance in two stages:
- first, a reduction in the eurozone equity markets’ double discount vs. the US and then, once political risk has evaporated, a fall in the French equity discount vs. the eurozone. Markets are currently hesitating due to doubts the Trump administration can roll out its promised reform programme and we see this period as a genuine opportunity for the eurozone to perform well.
- second, this trend will need to be cemented by signs that the eurozone profit cycle is genuinely robust. Today, for the first time since 2010, a strong recovery in eurozone leading indicators suggests earnings are rising. Indeed, they have recently been revised higher following guidance from companies reporting quarterly results. This second point is crucial as our scenario was not a bet on the election but based on the firm belief that political risk was mitigated by today’s favourable macro and microeconomic environment.
Market performance will also depend on reforms effectively being carried out in France, including:
- privatisations or government disposals of stakes which might trigger consolidation. (The government’s sale of its stake in Orange would herald telecom sector consolidation but in return for commitments to innovate and invest. Likewise, a reduction in the government’s holding in ADP could work in favour of a natural buyer like Vinci),
- reduced labour costs (with the recent CICE tax credit plan maintained) which would be good news for labour-intensive domestic sectors, i.e. companies like Veolia, Carrefour, Peugeot and Eiffage,
- simplified taxation of savings which could encourage investments in risk assets and away from property.
The most significant measure would be cutting corporation tax.
Stock-picking is back in favour
The market enjoyed a vigorous rally after the first-round results on reduced risk aversion. There is still further upside potential but we can now focus on fundamentals like results, previously overshadowed by political turmoil. Note that mid cap stocks have outperformed in recent months, proof that similar profits are treated differently when made by companies which are seen as less likely to be affected by elections. In recent days, the market has quite logically bid up financials which act as a barometer for eurozone risk. The bank balance sheet/sovereign debt link is still a powerful one (even if sector transformation since the 2011 sovereign debt crisis has reduced its impact). Financials, after all, would be very badly hit by any eurozone exit due to the impact of debt redenomination on assets/liabilities, liquidity risk and capital flight, etc.
This sector hierarchy is also reflected in country performance with peripheral countries like France and Italy outperforming core eurozone countries. Domestic stocks, hitherto held back by doubts over the ongoing economic upturn, are now free to perform. This is benefiting banks (again) but also construction, utilities and telecoms instead of export or visible growth stocks which were already trading at high valuations due to various flight-to-quality phases. In short, after underperforming when the post-Trump election rotation had run out of steam, value stocks, large caps and companies exposed to Europe's periphery are now generally outperforming. The one exception to this return to value investing is to be found in oil and commodity stocks but they are by nature less domestic and more associated with OPEC and Chinese issues than political events in France.