Making waves across the channel

France and the UK have both undergone an election, producing outcomes that provide an intriguing and attractive opportunity set. We reexamine our overweight to European equities, and although it may take some time for the dust to finally settle, in this paper we consider the political outcomes, the economic implications, and the potential opportunities that our investors should be considering going forward.

Vive la France

Markets breathed a sigh of cautious relief on Monday, after no party in France gained an overall majority. This alleviates concerns surrounding the more extreme agenda items, which could have weighed on public finances and European stability. There will be a rocky path forward, and forming a coalition from the current grouping will be challenging. French legislation does not allow for another election to take place in the next twelve months. ​

However, populism remains the dominant factor across the political spectrum, the price of which remains a loosening of the fiscal purse-strings. The broad right-wing and left-wing coalitions will find compromise within their own grouping difficult, and this will only be exacerbated when it comes to a program for government within a coalition. The rival coalitions’ agendas are very far apart, and we have already seen infighting within the left-wing alliance as to leadership posts. We believe that the French government will remain in a stalemate, which will need to see heavy dilution of any policies for any coalition to be formed.

The more extreme parties will do little to address legitimate concerns around the French public finances. Any coalition will be challenged in attaining parliamentary support for the next three years, which will also likely see a continued deterioration in France’s deficit and public finance in the coming years.

Markets believe that France, and Europe, have avoided the tail scenarios, and that stalemate will dilute any of more extreme parties and policies. This will be seen in an improvement in equity sentiment, as well as bond markets. Saying this, the Centrist Macron led coalition will likely need to compromise also, and it is difficult to see how this would not imply more fiscal loosening given the left’s policy agenda.

Rule Britannia

There was a rather muted market reaction given that the Labour landslide victory was expected. UK equities rallied on the margin, and sterling has improved slightly versus both the euro and the US dollar. The outcome had largely been priced in by markets, with sterling having already made gains in months prior to the election.

As much as the election results were positive for Labour, it was as much seen as a vote against the Conservative party as they suffered one of their worst ever defeats, as voters made it clear that they want to move away from a government that they associate with incompetence and chaos.

A stable and structured fiscal approach is welcome, and communication with the debt markets has been imperative. The government has made modest additional spending commitments of +0.3% of current GDP, broadly funded from tax increases. This will not fuel excitement, but of course, a rerun of the exciting 2022 mini budget is exactly what they wish to avoid. However, to deliver on their growth strategy, they will need to seek wiggle-room, particularly around targeted project debt structuring.

Policy shifts on loosening planning restrictions will not be straightforward, and require significant navigation skills, and goodwill from the electorate. The restructuring of the public business and infrastructure banks into the new national wealth fund indicates a solid move to a business-friendly approach of this administration. A positive outcome of the election result for both the UK and Europe remains that it increases the potential for a closer trading relationship with the European Union. This is likely to be on the agenda at the European Political Community Summit, set to be held on the 18th and chaired by the new Prime Minister.

Our take

Uncertainty will remain, and many doomsayers will point to the fact that France has only delayed the extreme outcome by a year, and the UK will inevitably end up there, with the robust performance of the right-wing. Political events play a key role in the governance of our strategic and tactical outlooks. Historically, we can see that wider geopolitics does indeed have shorter-term asset price ramifications and spikes in volatility around events. However, through time, unless these events cause systemic economic shifts, they tend to dissipate in importance, and the economic fundamentals prevail in the longer term.

We favour European equities, and we feel political events have delivered an opportunistic entry point, rather than derail our overweight position. Within European equities, there are no major sector valuation bias, unlike in the US. Technology is the most expensive with companies like ASML trading at high multiples, however many sectors are trading below their 10-year average (Comm Services, Staples, Energy, Utilities, etc). Sectors like Utilities, Staples, Comm Services & Tech tend to benefit from rate cuts historically. European earnings per share (EPS) have been stronger than most investors appreciate, and we feel may surprise on the upside, driven from economic growth rerating.

Inflation across Europe has become anchored, allowing the European Central Bank to have already cut interest rates in June. Additional interest rate cuts are expected over the coming twelve months. We expect risk sentiment to remain fragile towards France, with uncertainty remaining. However, the tail has been removed for now, and the underperformance of French assets offers an opportunistic entry point. The potential for excess returns in Europe is buoyed by attractive valuations and an economic cyclical upswing.

In the UK, inflation has also retraced back to its 2% target, which in turn should allow the Bank of England to start cutting rates soon, maybe even as soon as August. The UK consumer has been more susceptible to the recent higher interest rates; therefore, a reduction will be a welcome confidence boosting catalyst. Any thawing and improvement in trade relations with Europe would be taken well from investor’s perspective and add to the positive momentum. Furthermore, the UK remains relatively attractive a valuation basis, trading on price-to-earnings multiple of only 11.7 times versus global equities at 20.5 times. This cheaper multiple offers an attractive springboard to produce excess returns.

In summation, our overweight to European equities is maintained, with relatively cheap valuations, attractive entry levels, falling costs of capital, and several potential catalysts that could support outperformance going forward.

If you would like to discuss anything covered in this article, please contact your Davy adviser.