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European recovery takes centre stage but dangers still lurk

By Chris Hiorns, Senior Fund Manager of the Amity European Fund
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The EU received a welcome reprieve with the election of centrist Emmanuel Macron as French President. For now, the powerful tide of populism has receded in the West. However, while his victory was decisive and Europe’s growth engine is recovering, investors should not become overly complacent, as both France and the European project face challenges ahead.

After the anti-climactic French Presidential race finish, the reality is we are now heading into a fresh vote in the Fifth Republic – the legislative elections in June. Macron’s En Marche! party is a newly formed vehicle, and it, therefore, lacks the political machinery of the more established parties. This could hinder Macron’s prospect’s to gain a stranglehold on parliament. One scenario is after a failure to win control, Macron is forced to seek a coalition, which would weaken his ability to enact policy. 

Macron faces power struggle

While Macron has injected a fresh dose of blood to parliament with an eclectic list of candidates, including eccentric mathematician Cédric Villani, and bullfighter, Marie Sara, there is a real danger incoming candidates lack the sufficient political experience and cohesion for Macron to forge a stable and competent government. Furthermore, he has been far better at attracting socialist candidates than right wingers. Yet Macron showed hard-edged strategic nous by appointing Édouard Philippe as Prime Minister from the centre-right to destabilise the Republican fight back.  One thing is clear: there is plenty of potential for instability and shocks for the markets.

One other potential flashpoint is Macron’s intent to slash corporate tax and 100,000+ public servants. These radical policies have a neo-liberal flavour and may cause industrial unrest, ensuing market volatility. For now, investors must view En Marche! as an unknown quantity. On the positive side, we welcome the fact that, in order to show his progressive credentials, Emmanuel Macron has delivered on his promise that half his party’s parliamentary candidates would be women.

Franco-German relations may strain

Macron’s victory march was to ‘Ode to Joy’ – the EU’s anthem – underscoring his commitment to the European project and was a badly needed symbolic victory for the besieged union.  But what future direction the EU takes may cause fresh tensions between France and Germany.

Macron is likely to favour more integration into Europe something which Merkel is set against.  Friction will also increase if Macron champions a protectionist Europe, and Germany purses a more open market.  Political rifts may be inevitable. For example, the new French government may demand a new fiscal transfer mechanism, a measure ideologically opposed by the Germans.

Meanwhile, I think the German elections are looking very unexciting, and Merkel may well find a route back into power. What is far more unsettling as a future political event, which may cause uncertainty, is the spectre of the Italian elections in 2018.

Europe still offers compelling relative value

Overall, we expect some volatility from political undertows; however, the general outlook for European equity markets is broadly positive as the European recovery gathers pace.  We did see some softness in Q1, but now further positive signs are emerging and we may see increased momentum in job numbers, company earnings and real GDP growth.

Furthermore, from an asset allocation point of view, Europe looks relatively cheap when compared to the US. Furthermore, we are now seeing a reversal of flows from the US towards Europe which is a strong positive for the European equities market.  For investors, the discount window between European and US valuations is closing.

While earnings are likely to be stronger in more cyclical areas, less cyclical areas – still linked to European GDP and economic activity – may also perform strongly.  In terms of market cap weightings, I think larger European names represent good value.  Furthermore, selectively, utilities and telcos, which have both heavily underperformed the market over the last year or so, also represent value opportunities.

Europe still faces political hurdles and in, absolute returns, its markets have rallied strongly. However, it still offers compelling value from a relative standpoint, particularly when you consider US equity valuation and fixed income dynamics.

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