INSIGHTS

On April 25, 2017

The French Connection

With the markets relieved about the two choices in the final election in France offering a moderate selection rather than a dynamic binary choice, we have moved back to the “concern du jour.” The good and bad of expiring shelf life of news cycles is that weather forecasts now are stable. The currency markets are pricing in a moderate centrist winning the election with almost zero chance of a populist taking the seat. Though that clearly is the most logical scenario, I would caution that we have been down this road a couple of times within the last year.

The Brexit vote and our own U.S. Presidential election were given very little chance for what ultimately became the outcome. So while logic dictates the solution that is most probable, one must guard against the confirmation bias that inhabits all of us. The sovereign government markets have seen a risk off move as well, however, they still remain a bit pragmatic about the outcomes. With the abstention vote running at nearly 24% — well above the normal 20% — a lead for Centrist Emmanuel Macron of anything less than 30% over Populist Marine Le Pen should throw a contemplative pause for any assumption moving forward.

So while the rally is a relief of sorts, it is important to know that the last two occurrences of surprise votes, the resulting impact was all-time highs on the equity markets in the United Kingdom and United States. Should the surprise vote occur, it is no reason to fret. In fact, I would argue that we may be in the ideal “habitable zone” for growth in the European zone no matter the result under the two candidates remaining. We have a recent precedent of markets rallying and economic metrics improving after the UK and U.S. votes. The other option is the mainstream moderate winning; however, the status quo is already under fire in Europe and both national and Eurozone politics have to become more accommodating or risk the European Union dissolving over the next five years. This means the large bureaucracy the resulting high levels or regulations will soon wane in the form of more accommodative and competitive policies. The most recent and stark example of this is the European Central Banks shift in discussing potential changes in their policies and German politicians pushing more nationalist policies and border warnings to Turkey. Though this transformation is not as stark as seen in the United States, it is welcome to the business climate.

Though this evidence of being bullish on Europe can be classified as anecdotal we look at the overweighting of European equities based on more fundamental metrics.

• Global Purchasing Managers Index (PMI) is still running at very significant levels; the JP Morgan Manufacturing Global PMI is running at 53.0 with their services PMI component is at 53.6. Accordingly, that would project Global Real GDP at 3.2%.


• According to Capital Economics, the Eurozone PMI is at 6 year high and would correspond to a 0.7% quarterly GDP growth in the second quarter. We would correspond this with economic growth rate of over 2% which would be relatively hyper growth to the stagnation they have seen over the last few years.


• Perhaps one significant note is that the most recent numbers show France’s Purchasing Managers Index rising while the German measure declined.


• Where Germany may have slipped in the most recent numbers, one number is perhaps more important and more revealing. The German LFO index which is a business climate index rose in contradiction with the decline in the PMI. In fact, the current number is at a level that has only been reached 3% of the time over the last two decades. Accordingly, some say the estimates of this index would correspond to 3% growth rate in the next 12 months.


• Consequently, Global Earnings is seeing upgrades in the first quarter for the first time in six years. Earnings estimates have started out higher and then been consistently revised downward since 2012, however, so far we are seeing estimates being upgraded rather than revising downward. For first quarter estimates, consider the following comparisons with the United States and Europe.

Source: RBC

• One way to measure risk in the European markets and the election is comparing the French 10-year sovereign bond (referred to as OATs) versus the German 10-year Bund. It hit a recent high of 79 bps (basis points), well off its all-time highs of 151 bps. It has declined substantially since the election on Sunday to 50 basis points. This is prudent, in our opinion, in that it represents a potential scenario where the final result in two weeks could be closer due to the high level of abstention votes.

Europe continues to be overweight in light of the fundamental economic and market metrics. Though there has been a substantial relief rally, do not be surprised to see some choppiness as the election finally comes to a concluding result.

CRN: 2017-0411-5905R