French elections: markets switch on risk

Global stocks rallied, the euro hit a five-month high and French government bonds rose after the pro-euro and centrist candidate Emmanuel Macron came first in round one of the French presidential vote in an outcome that lessens the risk of a Brexit-type shock on financial markets. Polls suggest Macron is likely to beat his far-right counterpart Marine Le Pen on May 7 by more than a 20 percentage point margin. Yet with France’s political establishment having been marginalised, what can investors expect to unfold in Europe’s second largest economy?

Populism held in check but gridlock a potential risk

Even if Macron wins the race to the Élysée Palace, it would be premature to suggest that populism has been dealt a mortal blow in Europe. After all, the far-right Marine Le Pen and hard-left anti-euro Jean-Luc Mélenchon together received more than 40 per cent of the vote in Sunday’s ballot. At this point, it is not clear what proportion of those votes will go to Le Pen in the second round run-off.

Complicating matters further, even if Macron emerges victorious, his En Marche! movement lacks the infrastructure of a mainstream political party. This, in turn, will make it difficult for the centrist to build a power base in the National Assembly elections in June. The upshot for investors is that France could enter a period of political gridlock at a time when Europe demands strong leadership from its second largest economy.

Sustained upside for European stocks as focus shifts back to fundamentals

For all this, investors have justifiably breathed a sigh of relief. Sunday’s first-round vote helps remove the immediate risks to Europe’s political and financial stability. The yield spread on benchmark five-year French government bonds over German bunds fell to 50 basis points, compared with 80 in February and a peak of 180 during the sovereign crisis. The upside for French bonds may be limited - we expect the yield spread will have difficulty falling below 40-45 bps especially as the European Central Bank prepares to normalise its monetary policy.

In the near to medium term, we think the French vote should strengthen the case to buy European stocks.

With the political climate a little calmer, investor attention should now turn to European fundamentals, which have been improving markedly in recent months. 

France’s composite Purchasing Managers’ Index, for instance, recently hit a six-year high, putting the gauge above Germany’s for the first time since 2012. Domestic money and credit conditions in France are also among the most favourable in the euro zone. The euro zone’s economic recovery remains resilient, thanks to a combination of better transmission of monetary stimulus from the ECB into domestic economies, improving external conditions and modest gains in the labour market.

More broadly, European stocks already enjoy a strong valuation advantage over their US peers. Our composite indicators of valuation in European stocks stand close to a 20-year low. Moreover, since the start of the year, analysts have upgraded 2017 earnings growth estimates for Europe to 14.5 per cent, while cutting US estimates to 10 per cent.^[1] This gives investors an opportunity to shift their allocation in favour of Europe.

Corporate optimism on Europe has also been running high, with a record USD345 billion of foreign money flowing in to the region in the first quarter in merger and acquisition deals (see chart). Experience tells us that such flows often foreshadow a capital reallocation among pension funds and other institutional investors. Over time, then, we believe investors are likely to respond to the brighter business outlook in Europe and increase their holdings in European assets.

corporate optimism running high

Volumes of M and A deals into Europe by foreign buyers hit record high

Banking stocks should offer an attractive opportunity, especially as we think the ECB will soon lay the groundwork for a normalisation of its monetary policy in 2018. We expect the ECB to remove an easing bias in the next two meetings by announcing a cut in bond buying, to take effect next year. A much stronger euro could limit a recovery in corporate earnings, but financials and domestic-focused companies are less affected by the level of the euro.

Elsewhere, we expect Macron’s policies to favour industries which are heavy users of labour, including food, retail, services and manufacturing.

macron vs le pen's policies