Can Europe’s politics match its economics?

The euro’s rise – reflecting economic strength

Europe’s economy is firing on all cylinders, with growth running at its fastest rate post-financial crisis¹. Even traditional laggards are gaining ground: Italian business confidence hit a decade-high in September, and Standard & Poor’s reinstated Portugal’s investment grade credit rating. This strength has been reflected in the euro’s rise, which has flown in the face of interest rate differentials: 12% versus the dollar year-to-date, more than half of which took place after we boosted euro exposure in certain client portfolios in June². We recently increased these positions, taking advantage of what we saw as a temporary pullback in the euro’s advance after the announcement of long-awaited US tax reforms.

Even now, we note that the euro does not look very strong on either a trade-weighted or historical basis. Nor are we overly concerned by its effects on trade or monetary policy. A strong euro should not tie the European Central Bank’s (ECB’s) hands, given the low correlation between the currency and inflation. The link with trade’s contribution to growth also appears weak, except during periods of extreme overvaluation. European stocks have risen this year despite the euro’s gains, with earnings forecasts now largely pricing in a stronger currency. We see growth, monetary policy re-synchronisation and current account dynamics favouring further euro gains ahead. And we remain overweight European versus US stocks, given lower valuations, the earlier stage in Europe’s economic cycle, and strong domestic demand, favouring sectors such as banks, industrials, healthcare and IT.

Political complications

Yet for all its economic strengths, Europe retains its share of political adversity – the main downside to our positive outlook. This includes the ongoing immigration crisis, the rise of far-right parties, Brexit, and stalemate over further EU expansion. Germany’s recent elections were just one example of these problems. While Chancellor Angela Merkel hung on to power, the anti-immigrant AfD party won a worrying 13% of the vote, and the liberal Free Democrats are likely to enter the governing coalition – a party fiercely critical of greater Eurozone integration. Ms Merkel’s position has been weakened, complicating policy-making, and heralding tough coalition talks in coming weeks. Meanwhile, the violence surrounding Catalonia’s independence vote on 1 October has also substantially raised the political heat in Spain.

One important effect of Germany’s elections may be their impact on Italy. Some investors fear likely new coalition partners the Free Democrats could try and impose more fiscal discipline in Europe, curbing aid for more indebted nations. This could pose problems for Italy, where high public debt and banks’ non-performing loans could cause problems once the ECB starts normalising policy. Others fear Germany’s ballot could foreshadow a populist uprising in Italy, which must hold elections before May 2018. Spreads between German and Italian 10-year government bond yields have widened in recent months, adding another 2.7 basis points the day after the election result.

Are politics reaching an inflection point?

Europe has arguably made little political progress in the past decade; one reason why we believe it has lurched from crisis to crisis. Yet despite its many problems, today we see a nascent political revival, as the ‘old guard’ is replaced by a new generation of leaders keen to make the bloc more flexible and responsive to popular concerns. Matteo Renzi’s stunning 2014 rise to power in Italy (albeit now ended) was among the first signs. In the past 18 months, 39-year old political outsider Emmanuel Macron managed to found a new party and become French President. In Austria, 31-year old Sebastian Kurz is in poll position to become Chancellor in October’s ballot. While these individuals reflect a rainbow of political persuasions (Macron is a liberal progressive, Kurz a conservative nationalist), they share an ardent pro-EU vision. Both favour a strong European stance on foreign, security and defence policies.

In fact, a special summit in Bratislava shortly after June 2016’s Brexit vote started a vibrant and ongoing debate on new ways to reform the bloc. This gathered pace in September with two high-profile speeches: by EU Commission President Jean-Claude Juncker and Mr Macron. The former spoke of combining the roles of President of the European Council and Commission and creating a Eurozone finance minister. The latter set out his own radical visions for deepening the European project during an impassioned, nearly two-hour discourse in Paris.

Both made some excellent, and complementary points. Mr Macron’s suggestions included establishing an EU military force, intelligence agency and frontier police, and reducing the Commission’s size. His economic proposals echoed Mr Juncker’s calls for a Eurozone finance minister, as well as overhauling the Common Agricultural Policy and harmonising Europe’s corporate taxes, in part to fund an enlarged European budget. More integration would certainly help the eurozone: a common budget could improve convergence of bond yields and interest rates across the bloc, as well as its response to economic shocks. Although both Mr Juncker and Mr Macron stopped short of calling for full fiscal union (no word on mutualising debts), their speeches again raised the spectre of a common ‘eurozone bond,’ an instrument which might have curtailed Europe’s banking crisis. Perhaps the most important points in both speeches were the less newsworthy ones: championing a multi-speed Europe, better facilitation of cross-border labour markets, and ways of ensuring individual country’s commitments to structural reforms are honoured.

Of course, many of the proposals would doubtless meet with strong opposition. Both Finland and the Netherlands have in the past opposed more fiscal integration. Germany’s Free Democrats do too. But previously cautious Ms Merkel gave her clearest sign yet of supporting such reforms on 28 September, praising Mr Macron and saying there was a “high degree of consensus” between Europe’s largest countries. And given Mr Macron’s dogged pursuit of French labour reforms, tax and spending cuts that previous incumbents have judged way too toxic, there are grounds for optimism that at least some of his European ideas may materialise.

Now or never for reforms

Having spent much of the last decade fire-fighting, Europe’s economy is now in its best state in recent memory, giving the bloc a once-in-a-generation chance to change. Charismatic young politicians could sell reforms, and build a multi-speed bloc more responsive to popular demands and less prone to future exits, with supply-side measures to boost competitiveness, productivity and trade. The crunch time for such proposals could be during EU budget discussions next year. Nothing less than the future of Europe may depend on its leaders taking up the baton.

¹ Eurozone second quarter growth hit 2.2% year-on-year according to official statistics agency Eurostat
² Euro/dollar year-to-date gains quoted as of 3 October 2017.

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