The recovery in the Eurozone economies is firming with respect to private consumption and investment, with higher employment and labor income, according to the European Central Bank (ECB). Yet financial markets are on edge as a result of heightened political risk, with important elections coming up in the Netherlands, France, Germany, and probably Italy.
The economic news has been decidedly positive. Eurozone real GDP advanced by 0.4% in the fourth quarter, continuing the steady pace of quarter-on-quarter increases that have ranged between 0.3% and 0.6% since mid-2014. These figures have been somewhat above estimates of potential output. The January Markit Eurozone Composite Purchasing Managers Index (PMI), which covers both the manufacturing and service sectors, indicates that the Eurozone economy is growing at its fastest pace since mid-2011. Jobs are being created at the fastest rate since February 2008. An index of companies’ expectations about levels of output one year ahead has reached its highest level since the series was created in July 2012.
For France the January manufacturing PMI registered a 67-month high, with the sharpest increase in job creation in over five and a half years and marked expansion in both output and new orders. Similarly, the manufacturing sector in the Netherlands, as measured by the January manufacturing PMI, experienced sharp expansions in both output and new orders, along with the largest rise in new jobs in almost six years. Germany’s manufacturing sector, the Eurozone’s largest, grew at its fastest pace in three years, with both output and new orders accelerating.
We might expect that with this positive economic news the Eurozone equity market would be outperforming. But largely because of increasing political headwinds, that has not been the case. The 2.89% total return year-to-date (as of February 15) registered by the iShares MSCI Eurozone ETF, EZU, is half the 5.93% return of the iShares MSCI ACWI ex-US ETF, ACWX, which tracks large- and mid-capitalization non-U.S. equities. The German and Spanish markets did better than the Eurozone average, with the iShares MSCI Germany ETF, EWG, and the iShares MSCI Spain Capped ETF, EWP, each registering a 3.81% return. The Netherlands market did even better but still below the benchmark ACWX, with the iShares MSCI Netherlands ETF, EWN, earning 4.76%. The Italian equity market faired much worse, with the iShares MSCI Italy Capped ETF, EWI, registering a loss of 1.57% year-to-date on a total return basis.
In discussing the heightened political risk affecting the Eurozone markets, mention first must be made of the uncertainties surrounding the United Kingdom’s intention to exit the European Union (“Brexit”). Brexit is not a new development, but in recent weeks it has become increasingly evident that the break will be “hard” in nature, involving the loss of duty-free access to the EU’s Single Market. Several years at least of difficult negotiations lie ahead, with continuing uncertainty about the final outcome and implications for both the UK and Eurozone. The arduous and uncertain path ahead is not favorable for capital formation.
It is the uncertainties about the upcoming elections, however, that appear to lie behind the recent repricing of risk. This dynamic is most evident in the bond markets, where the spreads between French, Italian, and Spanish bonds and equivalent-maturity German bonds have widened. While the political uncertainties in Italy and Spain are not new, the deepening political turmoil in France has clearly unsettled investors. The far-right National Front leader, Marine Le Pen, riding a populist surge of anti-immigration sentiment, has the lead in the polls and is projected by many to win the first round of voting on April 23rd. The two candidates with the most votes then advance to the second and final round of voting on May 7th. The polls indicate that Ms. Le Pen is substantially behind any of the candidates she is likely to oppose in that round, as her views are too extreme for the majority of French voters. But confidence in political polls has been seriously undermined by their failure to predict both the Brexit and Trump populist victories. And these are not normal times for French voters who have been living under an official “state of emergency” for some time. Investors have to consider the possibility of a Le Pen victory, even though it remains a tail risk.
As one of her stated policy objectives, Ms. Le Pen proposes to take France out of the euro (“Frexit”), return to the French franc, and redenominate and devalue the country’s debt in francs. This course would clearly entail a sovereign debt default, which would be a huge shock to Europe and to the future of the monetary union. It is not surprising that a large burden of responsibility is being placed on the candidate who may oppose Ms. Le Pen in the second round of voting.
Until the last week of January it was widely believed that the center-right candidate, former Prime Minister Francois Fillon, would win the final round of the election. His pro-market views were reassuring to investors. But his candidacy is now in trouble following the opening of a judicial inquiry into Fillon’s possible misuse of public funds regarding the employment of his wife and two of his children. The legal issue is whether they actually performed the tasks for which they were paid. Fillon’s popularity has subsequently slipped behind a new front-runner and political newcomer, Emmanuel Macron.
Macron is a 39-year old former banker and ex-minister who appears to be taking the economic center of French politics. He served in the Socialist government but is running as an independent, claiming that he “transcends” the French parties. That looks like a wise move in view of the shambles both the Socialist and Republican parties find themselves in. The Socialists have chosen Benoit Hamon, a former education minister, as their candidate. He says he will seek to reduce the workweek from 35 hours to 32 and to tax the use of robots. He is very unlikely to make it to the second round. Meanwhile, the Republicans could be without a candidate if Fillon drops out, as he said he would if he is placed under formal investigation. Former candidate Alain Juppé ruled out taking his place, and Nicolas Sarkozy has his own legal problems and was soundly beaten in the primary. In sum, there is great uncertainty about the French election.
The first European election this year will be in Netherlands on March 15. The populist anti-immigrant, anti-EU PVV party is projected to get the largest vote, winning some 20% of seats in parliament. However, they are not expected to be able to form a government. It appears to be more likely that a broad coalition of pro-EU parties will form a government. Also reassuring is the fact that some 79% of citizens disagree that the Netherlands would be better off outside the EU. But there could well be a period of uncertainty until the new government is in place.
The German election will be held on September 24th. While there are still seven months to go, the prospects look good for a market- and euro-friendly outcome, with Angela Merkel remaining as chancellor. Her approval ratings have recovered and now stand at a formidable 74%. She will be running against the Social Democrat candidate, Martin Schulz. As the former president of the European Parliament, he is a credible alternative, but he is unlikely to win against Merkel. The far-right populist, eurosceptic party Alternative for Germany (AfD) will likely enter the Bundestag for the first time but is very unlikely to play a role in the formation of the government.
Our base case is that in all three of these elections as well as in the possible election in Italy, the threat of a populist far-right, anti-EU government will be successfully countered. But the tail risk of such a negative outcome has definitely increased. For this reason, in addition to continued concerns about weaknesses in the Eurozone banking systems and the uncertainties with respect to Brexit, we remaining underweight the Eurozone in our International and Global Portfolios.