Post-populist Europe on the edge of an economic turning point
By electing Emmanuel Macron, the French people affirmed their faith in European integration, and cleared the way for the continent’s policymakers to get back to the business of growth, writes Stephane Monier, Chief Investment Officer Lombard Odier, and Samy Chaar, Chief Economist Lombard Odier.
While the market has, in recent months, been blindsided by politics, the region’s recovery has quietly entered a new phase of economic confidence that suggests it can soon stand on its own two feet without the crutch of central-bank support. As a result, we believe that investors should now begin considering how they might position their portfolios for the end of negative interest rates.
As the continent progressively puts the eurosceptic threat behind it, existential concerns surrounding the future of the single currency, and the union as a whole, continue to be priced out of markets – leaving fundamentals with the room to reassert themselves, and uncovering a landscape of opportunity for investors.
In the run-up to France’s vote, European stocks underperformed the wider market and remain attractively priced after touching their cheapest level in five years1. This valuation dynamic is playing out against the backdrop of a Europe that is, itself, in the best economic shape it has seen in a decade, posting 14 consecutive quarters of growth, single-digit unemployment and a six-year high in economic confidence2. Meanwhile, with inflation appearing to be on the rise, European Central Bank (ECB) president Mario Draghi recently said there was no longer a “sense of urgency” in monetary policy – a statement that prompted gains in the single currency and set the stage for a new policy era that will ultimately be good for regional assets.
Towards the end of negative interest rates
With a combination of solid, diversified economic performance and improving market sentiment, Europe’s monetary policy framework is evolving. The ECB is shifting its rhetoric from “how to fight deflation” to “how and when to remove unorthodox accommodation”. With the last round of negative-rate TLTROs3 now concluded, the pertinence of negative deposit rates may soon be called into question. It is now, in our view, merely a matter of timing.
Based on the current rhetoric, it does not appear that the ECB is poised to raise rates quickly. We estimate that the unwinding process will be undertaken over a period of two years. While we expect the withdrawal of some accommodation this year, we are unlikely to see interest rates move into positive territory until the end of 2018. Either way, we hope the ECB will learn lessons from its US counterpart.
Lessons from the Fed
While the ECB has a three- to four-year time lag on the US Federal Reserve, it faces a much more complicated route to normalisation. The Fed, after all, never drove rates into negative territory and had a well-defined tightening sequence in mind: taper asset purchases first and only start to raise the policy rate after QE had concluded – with the final goal of shrinking the balance sheet. For Europe, concerns regarding the effects of negative deposit rates on the banking system may justify ending the negative interest rate policy before fully tapering the asset purchase programme.
That said, even with its well-defined process, the Fed’s first suggestion of tapering triggered a tantrum of volatility in 2013 that the ECB will want to avoid. More realistically, however, moving from a negative to a positive rate environment is unlikely to be a painless process. Choosing an opportune time to begin unwinding support remains one of the biggest balancing acts in monetary policy. Consequently, as Europe comes out of this period of political uncertainty, investors must brace themselves for some policy uncertainty in the months ahead.
…A final note on France
After the fanfare of his inauguration, Emmanuel Macron will have sat down to an in-tray of much-needed fiscal reforms, employment laws that are unfit for purpose, and pressure to drive greater EU integration. While we do not doubt his commitment to reform, we remain vigilant against a political surprise – be it positive or negative – as he complies a cabinet of enough political colours to garner him sufficient support at parliamentary elections in June.
As France’s youngest-ever leader, Macron could stand as a beacon for change in a country that greatly needs it. Alternatively, he could prove to be a mere sapling with the potential to be quashed by the forces of France’s status quo. Either way, he faces a tough challenge in steering one of the union’s largest economies out of a spiral of high unemployment and sluggish growth.
Ultimately, we see France as central to the European recovery story. As the momentum of populism fades, Macron and his counterparts across the continent must address the economic challenges that brought populism to their doorstep in the first place. In doing so, they will fashion a more enduring recovery, which will benefit France in the same way that an economically stronger France will, in turn, benefit the union.
While our positive stance on European assets holds strong – on grounds of valuation and fundamentals – we are closely watching the progress of Macron’s reforms as Europe begins the process of turning this very tight economic corner.
1 Relative to US equities as measured by the S&P 500 (based on expected earnings for the next 12 months). Source: Bloomberg as at April 2017.
2 Source: Bloomberg, May 2017.
3 Targeted long-term refinancing operations.
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