Former Minister for the Economy, Emmanuel Macron, defeated the populist Euro-skeptic candidate Marine Le Pen. He did this by taking more than 60% of the French Presidential runoff vote. At age 39, he is the youngest President in the history of the Republic and he had never held an elected office. He proposes to reform France by taking the best ideas from the left and from the right. There has been much discussion about what this may mean for France. We believe the more important question is: what does this mean for the Eurozone?
The Euro came into existence on January 1, 1999. The notion of a single European currency was discussed by the League of Nations in 1929 in the aftermath of the First World War on the belief that economic integration and a common currency would create an impediment to military aggression. After the Second World War, the movement gained momentum and after years of analysis, planning and negotiations, a monetary union was created and over the years has expanded its membership.
To be clear, the impetus for the union was political. The focus has been on centralizing monetary policy that is established and carried out by the European Central Bank (ECB). The agreement signed in Maastricht established limits for budget deficits, but was so contentious that framers agreed to forgo the creation of a fiscal union for fear of failing to achieve even a partial deal.
Some describe the resulting situation as a 2-legged stool. There is a centralized political body, the European Union, which sets rules for economic integration and a monetary institution, the ECB. The member countries are entirely on their own, within limits, with regard to fiscal measures such as public spending and taxation. More recently there has been progress toward a banking union with a centralized facility to stabilize and regulate banks plus deposit insurance.
Germany and then France, are the two largest economies in the Eurozone. Companies headquartered in Germany and France benefit greatly from the preservation of the Euro.
The great financial recession nearly destroyed the Euro. Greece defaulted. Ireland, Portugal, Spain, and Italy all needed support from the ECB and the International Monetary Fund (IMF). Ireland has since recovered. Spain’s economy has expanded after a period of austerity but unemployment remains extremely high. Meanwhile, Portugal and Italy have languished. Banks suffered in the great recession and governments loaded up on debt when they assisted the troubled banks.
In the United States, when a particular state or region goes into recession, targeted fiscal stimulus can be applied to aid an industry (as with the cash for clunkers program to help the auto industry) or can aid a particular place via the construction of transportation projects to create jobs. Monetary levers used to increase or lower the benchmark borrowing rate to control economic growth is a blunt instrument. For example, lower interest rates are of little help to a homeowner who is failing to make mortgage payments because he has lost his job. The absence of fiscal levers has led to a protracted stagnation among the peripheral countries and has created a challenging environment for the stronger countries, like Germany, who would benefit from exporting to their other Eurozone neighbors.
Italy is the third largest economy in the Eurozone. It has endured a longer period of stagnation than Japan. Like Japan, Italy has an aged population and a very high level of Government debt as a percentage of its Gross Domestic Product (GDP). The people of Italy are fatigued. It is small wonder that populism is on the rise. The Five Star movement led by comedian Beppe Grillo taps into the frustration with a Euro-skeptic message. The movement is currently supported by nearly 30% of the voting base of Italy. This is significant given that there are 11 major political parties in Italy. Italian parliamentary elections are required to be held by May of 2018. So while the Netherlands, and now France, have avoided the election of an anti-Euro populist and the German Christian Democrat centrist, Chancellor Angela Markel, appears to be a safe bet for re-election this fall, Italy is a much higher risk. Should the anti-Euro parties continue to strengthen and Italy opt out of the Euro it could mean the end of the Euro.
Should Merkel and Macron work swiftly and effectively to add the third leg to the stool, a fiscal union, the disaster could be averted. In order to get buy in, they would have to get Euro members to relinquish some of their control over taxation and public spending. Given the cultural differences of the various nationalities, this will not be easy. For Italy, the inducement would have to come as a transfer of debt to the ECB. Spain, Portugal and Greece would also want debt relief. The Netherlands and Finland may howl and threaten to leave the Euro. But in the end, the trade-off to preserve the currency, attain a new and powerful policy tool (fiscal) and keep larger albeit more fragile members in the fold but lose the Netherlands and Finland may be worth it. It is notable that on the second day of having taken office Macron met with Merkel.
While there are no immediate investment implications, Macron’s early strategizing with Merkel is momentous. It is worth noting that further Franco-German economic integration will weaken the United Kingdom’s position in bargaining trade terms post Brexit. Likewise it will be important to monitor political developments in Italy. A major departure from the Euro, such as Italy, will have global systemic implications for banking and trade. The Eurozone unification on fiscal policy should contribute to greater long-term stability for the region. Having a complete set of policy tools will allow the Eurozone leaders to induce economic recovery more quickly aftershocks like the ones that ignited the “Great Financial Crisis”. All things being equal, the stocks of European companies that operate in the region should be afforded higher valuation multiples because the economy there should be less volatile.
Important Disclosures
Chautauqua Capital Management is a division of Robert W. Baird & Co. The opinions are those of the author and subject to change.
Past performance does not guarantee future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. Investments in international and emerging markets securities and American Depository Receipts (ADRs) are subject to certain inherent risks including difficulty predicting international trade patterns, currency fluctuations and the possibility of imposition of exchange controls, foreign taxes and regulations, lack of uniform accounting, and the potential for illiquid markets and political or economic instability. These risks are more pronounced in emerging market countries.
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