French Impressions

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We just completed a three-week visit to France.  Paris and the French countryside remain as lovely as ever.  On the surface, life in France seems normal, with shops, restaurants and hotels full, traffic heavy, and tourism intense. Indeed, arrivals at Charles de Gaulle Airport were so numerous that it took over an hour to get through passport control.  However, the country is in the grip of a growing malaise. The French economy is flat, with three consecutive quarters of zero growth. Surveys of business sentiment have not recovered from their free-fall early in the year. The external environment has deteriorated, with global growth slowing and much of Europe in recession. For the first time in 13 years, unemployment in France topped 3 million, according to figures released last week. It is not surprising, therefore, that the popularity of France’s recently-elected Socialist president, Francois Hollande, has dropped to 43%.  Any expectations that Hollande’s government will be able to fulfill their campaign pledge to revive the economy and curb rising unemployment appear to have dissipated.

There are increasing doubts that France will be able to maintain what commentators have called the French economic “exception,” that is, following policies that are counter to the direction in which other countries believe they must go if they are to avoid the wrath of the markets.  France’s public sector accounts for 56% of the nation’s GDP, a percentage that is second only to that of Denmark’s in Europe. France has not followed other European countries in reforming its labor market, choosing to preserve short work hours, heavy job protection, and early retirement. Hollande was quick to roll back some of the modest reforms of the previous government of Nicolas Sarkozy, imposing a tax on overtime work and reducing the retirement age for some workers.  Despite policies that defy orthodox economics, the markets have been kind to France. Since the election of Hollande, who also pledged to increase jobs in the public sector, the yield on French government bonds has declined, reaching a record low of 2% on the ten-year bond in early August, and is still only about 2.2%. This is despite the loss of France’s triple-A rating from Standard & Poor’s in January. There is a strong prospect that Moody’s will follow suit in the near future.

The need for France to develop and act upon a wide-ranging economic reform agenda was recently illustrated in the World Economic Forum’s Global Competitiveness Index for 2012-13. France’s rank fell to 21 from last year’s rank of 18. The rank of France’s most important trading partner, Germany, remains at 6. The growing difference between the global competitiveness of these two countries is very significant. Today, the September purchasing manager indices report states that there was an increase in manufacturing momentum across the eurozone, except for France where the PMI declined by a substantial 3.3 points.

If France is to stem this decline and also avoid what could be a steep increase in its cost of funding the large deficits, it needs to undertake a number of market-oriented economic reforms.  This will be a difficult task for the current government.  President Hollande has said that labor market reforms are needed to allow companies to adapt to changing global competition, but these reforms will need to ensure that employees are adequately protected and supported.  The government has also indicated that employees should be more involved in decision making. To have openly talked about increasing labor market flexibility is a step forward, yet clearly the government remains very cautious on this subject.  Little has been said so far about increasing competition in protected sectors and reforming the goods and services markets.

At the end of last week President Hollande presented his first annual budget. In accord with his pledge to reduce the budget deficit to 3% of GDP, the budget is “tough” by French standards, but unlike those of other countries in the eurozone, it does not contain large cuts in government spending and employment, pensions, and salaries. Instead, the emphasis is on higher taxes for the wealthy, large businesses, and investors. Tax increases account for 20 billion euros ($26 billion) of the 30 billion euros required to reach the budget deficit goal. Thus the ratio of tax increases to spending curbs will be 67 to 33.

The budget includes the promised levy of 75% on incomes over 1 million euros, which will apply to only 2000 to 3000 people and raise just a few hundred million euros.  There is also a new 45% marginal rate on incomes over 150 thousand euros and higher wealth taxes.  Moreover taxes on interest and capital gains are being increased to the rates on ordinary income. The higher taxes on business will apply to large companies and include reducing the deductibility of interest payments and the exemption on capital gains realized on profit-sharing and increasing certain social and pension contributions.  The 10 billion euros in spending cuts will involve spending freezes, a limit on the rise in state health spending, and reductions in the spending on defense. With these reductions, the ratio of public spending to GDP is still projected to remain level at 56.3% next year.

The budget is based on an optimistic projection of 0.8% growth in the French economy in 2013. In our view, a budget that falls heavily on those that are the greatest source of valuation creation in the economy will further delay the hoped-for economic recovery, with growth more likely to be no better than 0.5% in 2013, following an advance in the current year of just 0.1%. The down-side risks look to be significant.

In view of the above, the French equity market does not look attractive to us at this time. Over the second and third quarters, the return on the iShares MSCI France Index ETF, EWQ, was -0.78%.  Today the French CAC Index advanced by 2.4% and the yield on French government bonds is practically unchanged at 2.18%.  Apparently the “French exception” is still in effect.  Cumberland’s International and Global Multi-Asset Class ETF Portfolios currently do not include any positions for the French market (other than through broad, aggregate, multi-country ETFs).  The only eurozone-country positions currently included in these portfolios are for the German market.

Source: Cumberland Advisors Commentary

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About Bill Witherell