With his victory as France's new president-elect, Emmanuel Macron can celebrate – for now. Much depends on whether he can secure a parliamentary majority in June. Nevertheless, Macron’s win helps investors see the more positive side to the European story.
EU breathes a sigh of relief
With the election of Emmanuel Macron as France's next president, the European Union breathes a sigh of relief, although the results of the National Assembly election in June will have a significant bearing on his ability to accomplish his political agenda. Yet even with this resolution in France, some degree of political uncertainty
Some degree of political uncertainty will persist as Europe's ongoing 'super cycle' of elections continues
Mr. Macron's victory means France and the EU should be able to move past some of the more divisive issues raised during this presidential race, and investors can now start to focus on the positive economic story emerging in Europe:
- Mr. Macron is pro-euro and pro-European Union, and his victory is clearly a win for the EU – though it could make Brexit negotiations more difficult for the UK if France and Germany become more tightly allied.
- Mr. Macron's victory decreases the possibility of a "Frexit" from the EU and should prevent NATO from being further undermined.
- Ms. Le Pen's loss means a setback for the forces of nationalism in France, though her National Front party has developed a formidable amount of support. Anti-EU feelings can still resurface, particularly given that Mr. Macron remains a conventional, pro-establishment politician.
Two scenarios for Mr. Macron
Mr. Macron will need to cooperate closely with the incoming class of French legislators to have any hope of enacting significant policy changes.
As such, we see two scenarios to consider after June's elections:
Mr. Macron is pro-euro and pro-European Union, and his victory is clearly a win for the EU
- President Macron's party does not gain a clear parliamentary majority. Unlike Germany, France has less experience forming political coalitions, which could limit Mr. Macron's ability to pass reforms. Under this scenario, which we believe is more likely, the markets would be uncertain about his room to maneuver.
- President Macron's party wins a parliamentary majority. As illustrated by the market's reaction immediately after the first round of presidential elections, this scenario should be bullish for euro-area risk assets, such as equities and bonds from the peripheral areas of the euro zone.
In general, Mr. Macron's victory and the accompanying rejection of euro-phobia should reduce some of the market's worries about political risks. This should help investors concentrate on the more positive economic side to the European story.
- Macroeconomic indicators. Unemployment numbers look much better than they did three years ago, and many economic indicators show positive signs. For example, recent purchasing managers index numbers show steadily improving manufacturing output in the euro zone.
- Interest rates. Despite some investors looking for higher rates in the immediate future, we don't expect to see a real change for at least 6-12 months. Indeed, we also don't expect the European Central Bank to begin tapering until 2018.
Many euro zone economic indicators, such as manufacturing output, are showing positive signs
- The euro. The currency is likely to strengthen on the back of a better political outlook as well as better cyclical data and expectations of tapering in due course.
- Equities. There is a good chance that political risk will be priced out further. Based on our analysis, European equities – which have shown higher revenues and stronger order books and should continue to outperform global equities – will have further upside potential as political uncertainty declines.
- Fixed income. Our outlook for French government bonds is slightly positive. If Mr. Macron finds parliamentary support, we expect tighter credit spreads, a strong reduction of French-specific risk and tighter spreads in the euro-zone periphery; without it, we expect a mild risk appetite in fixed-income markets, with some event-driven spikes of volatility.
What's next for France – and Europe
While political developments make headlines that influence the financial markets, cyclical forces remain key drivers of performance. As long as the cyclical backdrop is positive, we should be in a good environment for risk assets – provided we don't get a clearly negative signal from the political realm. The outlook for monetary policy, both in the US and in the euro area, will also continue to be a key determinant for markets.
Mr. Macron's victory brings with it the potential for a new and constructive agenda between France and Germany
But politics continue to dominate much of the discussion for policymakers, voters and investors alike. We now expect the markets to turn some of their focus to Italy – the elephant in the room. It has an economy with weak growth rates, a weak banking sector and a governing party at risk of splitting up. If Italy does not hold a snap election this year, a regular election will be held in the spring of 2018. The risk of anti-European forces coming to power at either juncture is reasonably high.
Some degree of political uncertainty will persist as Europe's ongoing 'super cycle' of elections continues. Overall, however, Mr. Macron's victory brings with it the potential for a new and constructive agenda to be formed between France and Germany. This could help Europe move closer toward integration, and provide further reassurance for investors.
In high-priced markets, there are good reasons to look for innovative companies that thrive on disruption. Karen Hiatt says many are highly valued with good cash flows because they have essential products and services, which could bode well in a downturn.
Exiting too early can lead to loss
It is hard to ignore the fact that the US equity market is trading near record highs, with the S&P 500 Index more than tripling in value since its 2009 lows and price-to-earnings multiples near all-time peaks.
While some investors are still enjoying this run-up, others worry they might hold on too long. There is of course no way to identify the best time to buy or sell, but it is important to point out that some of the largest gains in an investment cycle are left to the end. Exiting too early can mean a sizable loss of opportunity.
In addition to maintaining one’s positions, there is another approach for investors to consider late in an economic cycle: Investing in companies that thrive on disruption can create significant value for their customers. Many of these firms are highly valued precisely because they have vital products and services that consumers consider essential, which could bode well in a downturn.
Innovation drives value
Consider for a moment the productivity-enhancing high-tech innovations that powered the growth of social media, cloud computing and ecommerce. These disruptive technologies triggered an interesting inflection point that is very different from the one seen during the tech bubble, which was fueled by red ink. Today’s most innovative companies have growing levels of free cash flow and the ability to drive their own profitability expansion, which makes them that much more valuable to customers and shareholders alike.
For example, the largest social media advertiser in the world continues to add value for its customers by improving the visibility of returns for every ad dollar spent. As advertising budgets become tighter in a downturn, their clients are more likely to invest their last ad dollars in a channel that can target engaged consumers and generate sales.
Also consider the largest providers of cloud computing, who offer the opportunity to reduce costs and increase productivity without requiring their customers to invest big capital budgets behind massive data centers and enterprise integrations. This flexibility is exactly what their customers need as economic tailwinds subside, when they look to optimize costs.
Finally, the largest ecommerce company in the world continues to invest in new services to improve the value of its annual membership: music, media, free delivery, books and digital storage. So when it raises subscription prices by 25 per cent in a single year, after many years of adding content to its service, there was very little pushback from customers even as the company enjoyed a significant boost to revenues.
The importance of active stock selection
Clearly, there are many options for managing portfolios in the later stages of an economic cycle. Shifting portfolios to more defensive sectors or cash is one traditional option, as is investing across a broad basket of securities to improve diversification.
However, given that a rapidly falling market has the ability to drag down entire asset classes, an active, focused approach may be beneficial during the late stages of a bull market. While no investment strategy can guarantee a profit or protect against a loss, investing in companies that offer differentiated consumer services and measurable returns could add the diversification investors need as the debate over market tops intensifies.