27 avril 2017

Election Disaster Averted. What’s Next?

April 27, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)

Emmanuel Macron and Marine Le Pen qualified for the second round of presidential elections in France over the weekend and will face each other in a run-off on May 7, 2017. Markets have welcomed the outcome with an impressive rally across European equities, peripheral European sovereign bonds and the common currency. But what do investors have to look out for beyond the relief rally? Let’s find out.

Macron Win Triggers Global Relief Rally

The day after the election, global markets sharply rallied in response to moderate candidate Macron succeeding in the first round of French presidential elections. In the equity space, France outperformed in Europe (see Figure 1), Europe outperformed globally (see Figure 2) and banks outperformed on a sector basis (see Figures 3 and 4). Several European equity markets even hit fresh multi-year highs (CAC, DAX, EuroStoxx). But gains were not limited to stocks. Rapidly tightening sovereign spreads also propelled European corporate and sovereign bonds higher (see Figure 5). In fact, most of the outperformance German sovereign bond futures had accumulated vis-à-vis their French equivalents since the start of the year were erased in a single session. In addition, the EUR jumped against most haven currencies such as CHF, JPY or USD (see Figure 6).

Europe Still Faces Many Political Risks

Despite resurfacing investor optimism, please remember that Mr Macron has not been elected president of the French Republic yet. True, he won the most first-round votes (see Figure 7). True, Ms Le Pen scored at the lower end of expectations. Also true, the two other moderate candidates eliminated in the first round (Fillon, Hamon) have endorsed him.

Still, there are good reasons to remain cautious. First, the margin of Macron’s success was slim. Even modest movements may turn the first-round result upside down. Second, as we have argued before, low voter turnout could considerably play into the hands of Le Pen, because her supporters are the most convinced among all original candidates. For example, the latest polls indicate 60% (40%) of French voters intend to vote for Macron (Le Pen). Assuming that Le Pen achieves at least 90% voter turnout on her behalf, Macron needs a minimum of 60% of his alleged supporters to actually show up at the ballot box. Given the resentment he enjoys from the left and right, we conclude that Le Pen still stands a slight chance to win.

But even if the second round of French elections passes by smoothly, Europe’s election marathon is still far from over. France will elect a new parliament in June, Germany will do so in September and Italy might vote towards the end of the year. In France, whoever becomes new president is unlikely to win a majority in parliament. Macron lacks a well-developed party and Le Pen’s FN a sufficient number of convincing MP candidates. So, how will France be governed? Probably, nobody knows. By contrast, in Germany most observers expect incumbent chancellor Merkel to win again. Here it is the precise outcome which is relevant for European politics. There are three possible scenarios: a big win, a small win and a defeat. If Ms Merkel wins big, she may gain some leeway to soften her stance on European issues. But if she wins by a small margin, she will need to cater to conservative claims which would likely lead to a more restraint touch on Europe. Should social democrat candidate Schulz beat Merkel, however, this could mean he has a mandate to considerably soften Germany’s handling of European fiscal affairs. Turning to Italy, where voters might be called to the ballots as well, the picture looks much grimmer. With no room for fiscal latitude and a decade of disappointing economic growth, anti-euro sentiment is rapidly building. Currently, merely one major party, ex-premier minister Renzi’s PD, supports the common currency. Against this background, doubts about the euro’s fade will likely resurface with every new Italian election. Italy, like France, is too big to fail or exit. Europe’s election marathon will therefore keep investors busy for the foreseeable future.

However, looking back at the recent Dutch parliamentary and (first-round) French presidential elections, European non-establishment parties turn out to have much less momentum than elsewhere, say the US or UK. In the Netherlands, Geert Wilders failed to win, and in France, long-time frontrunner Marine Le Pen only came in second. Against all odds, the real story about (continental) Europe is perhaps one of receding political extremes rather than imminent chaos and disintegration.

Euro Area Enjoys Strong Economic Momentum

Unimpressed by the constant flow of political jitters, the Euro Area economy considerably strengthened over the last two years (see Figure 8). The unemployment rate, consumer confidence and business climate have constantly improved since the peak of the Euro Crisis in 2012. All indicators are close to multi-year highs. With political uncertainty increasingly out of the way, the strengthening recovery stands to continue for some time to come.

Mind the ‘Trump Trade’

On the other side of the Atlantic, President Trump continues to preoccupy markets. After a rampant rally on expectations of imminent tax reform, some investors start worrying the market has run too hot. The new administration’s failure to secure a vote on repealing Obamacare has cast doubt on its ability to govern. More recently, AP reports, the tax reform bill has already been delayed. In addition, there is a potential for a government shutdown as soon as April 28, 2017, although its extent will likely be much smaller than in 2013. The new government also seems to have shifted its focus from domestic economic issues to foreign affairs, as Trump’s order to attack a Syrian airbase and repeated warnings against North Korea have shown. With geopolitical downside risks rising and tax reform upside vanishing, investors seem to reconsider their allocations.

In addition, the economic fundamentals do not seem to follow the direction of rising expectations after the US elections. Not only do business and consumer sentiment indicators exceed ‘hard’ macro data by the widest margin on record (see Figure 9), but markets seem to increasingly disconnect from economic fundamentals (see Figures 10 and 11). Interestingly, we find a similar divergence for both US and European equity markets.

Commodities at a Crossroads

Finally, we analyze the momentum of crude oil and copper to estimate the implied pace of global growth. Both commodities are implicit bellwethers of global economic momentum. Higher (lower) prices indicate strengthening (softening) demand relative to supply.

Both commodities suggest global growth is decelerating given that their moving averages (see Figures 12 and 13) seem to flatten. The effect is stronger for crude oil than copper. This development is in sharp contrast to the vigorous uptrend in the second half 2016. Hence, a new growth impulse is needed to revitalize the global economic expansion.

Shifting Political Uncertainty amidst Softening Economic Momentum

In our view, markets are currently undergoing a difficult adjustment process. While political risks are still high but receding in Europe, they are on the rise elsewhere; particularly in the US and East Asia (‘Korean Crisis’). Economic momentum simultaneously slows in the US and globally. Yet, markets have considerably risen over the last couple of months. This divergence means that markets look increasingly expensive relative to fundamentals and emerging political risks. Therefore, what is needed to better equate return and risks is either a new growth impulse, rapidly vanishing political uncertainty or a ‘healthy’ correction. Only time will tell.

Figure 1: Performance of French, German and Italian Equity Indices since the Beginning of 2017

Figure 2: Performance of Global Equity Markets since the Beginning of 2017

Figure 3: Performance of Broad-Based European Bank Equity Index on the Monday, April 24, 2017

Figure 4: Performance of European Large Cap and Bank Equity Indices since the Beginning of 2017

Figure 5: Performance of French and German 10Y Bond Futures since the Beginning of 2017

Figure 6: Performance of EUR against USD, CHF and JPY since the Beginning of 2017

Figure 7: Sum of First-Round Election Result by Political Alliance

Figure 8: Euro Area Unemployment (inverted), Consumer Confidence and Business Climate

Figure 9: Euro Area Unemployment (inverted), Consumer Confidence and Business Climate

Figure 10: US Economic Surprise Index vs. S&P500 (USA) and EuroStoxx50 (Euro Area) since the US Election

Figure 11: US Economic Surprise Index vs. S&P500 Bank and Materials Subindices since the US Election

Figure 12: WTI Crude Oil Futures vs. 50, 100, 250 Day Moving Averages

Figure 13: Copper Futures vs. 50, 100, 250 Day Moving Averages

Published on Riskelia’s Blog