A dramatic reversal of fortune in Europe
Monday, 2 December 2024 13:36
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More than a decade ago, southern Europe was facing a decisive moment, which eventually led to the Greek sovereign default and debt restructuring in 2012. But it also led to deeper EU integration and some form of debt mutualization. In other words, the euro area, and the EU more generally, has faced huge challenges since its creation several decades ago. But despite all the drama, it has always managed to overcome its difficulties and to move forward thanks to great political will. We expect this time is not different.
There is no doubt that the current situation is grim. France and Germany both face political instability, Trump’s election raises deep question marks for Europe, trade links with China have added vulnerability, not to mention Ukraine/ Russia. Uncertainty has moved from southern Europe a decade ago to the very core of the euro area now. France and Germany face common challenges in terms of weak growth and political uncertainty, while Spain, Greece and Portugal are expected to grow at, or above, 2% in 2025. This is a dramatic reversal of fortune, though we do not expect France and Germany to face the same financial turbulence than southern Europe in the past. Although France is struggling to cut spending and increase tax revenues, Germany has a lot of fiscal room to stimulate its economy. This is the key upside risk for Europe in 2025, considering the overall gloominess (read low expectations) across the region at present. But that comes with a big “if”, since Germans are not known for fiscal profligacy, which explains why public finances are in good shape.
In today’s weekly we focus on our expectations regarding France, in light of recent developments and market movements. With the fragmentation in the Parliament since the legislative election last July, the current government is extremely fragile and could be ousted in the coming weeks. The far-right wants to have a say in fiscal policy and is asking for concessions in terms of tax hikes which do not help towards reducing the deficit. Yet, markets have been relatively quiet. True, the OAT spread versus Bund continued to widen, but in smaller proportions than last summer. Also, the CAC 40 keeps underperforming, on the back of its cyclical bias (Capital Goods and Consumer Durables & Apparel represent 40% of the benchmark) but also due to uncertainties with regards to tax policy as exceptional levies could become permanent. Spain is creating a precedent in this area, as a supposedly temporary levy on banks was extended by three years and the Socialist government of Pedro Sanchez has pledged to work on a permanent energy tax…
We foresee 3 possible scenarios for the French political situation in the coming quarters. In all scenarios, we get parliamentary elections in July 2025.
- Scenario 1: the current government survives but uncertainty persists in H1-2025.
- Scenario 2: the current government falls and is replaced by another moderate government or by a technical government.
- Scenario 3: early presidential elections are organised after a resignation of Macron, which looks very unlikely to us.
Overall, we must admit that we don’t see many silver linings for French equities in the near term. Earnings expectations have been dramatically cut and underperformance is significant. But great opportunities arise when pessimism is high. It is a matter of timing and patience. In our view, geographical diversification outside Europe remains nonetheless important at this stage in equity portfolios. In rates, we don’t expect French sovereign yields to move significantly higher compared to current levels, which already priced in several rating downgrades. Said differently, the bulk of uncertainties are priced in in our view for the French Treasury market. Even if the government is ousted, the 2025 budget will be approved, and some deficit reduction measures will be implemented. There is no shutdown to be expected in France (articles 38 & 47 of the French Constitution allow the provisions of the Finance Bill to be brought into force by Ordinance should Parliament fail to reach a decision within a certain timeframe). If the current government is ousted, another moderate or technical government will be appointed by Macron. There is no reason to think that France’s perceived credit risk will deteriorate significantly as long as extremes parties, both on the right and on the left, stay at bay. Spain, Belgium, Netherlands and Germany all struggled to form coalitions in recent years. Belgium and Spain managed to do relatively well in economic terms without a government for many months (almost two years in Belgium!). What is happening in France has happened in the recent past in other European countries without market disruptions. Yet, time is ticking away. Structural reforms are delayed, austerity is being watered down by the populist far-right, and the 2027 Presidential election will then come fast.
Week ahead: in the US, the ISM business survey, the job market report and the University of Michigan consumer survey will be the main market movers from a top down perspective.
Cross-asset performance (last week, %)
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