A roadmap for Europe
The election of Emmanuel Macron as French president has diminished political risks in Europe, and the likely reelection of Angela Merkel in Germany should provide a basis for the implementation of deeper reforms, especially in the Eurozone.
As the Brexit shock dissipates, some steps toward greater integration and cooperation in the broader European Union (EU) may become possible as well.
Here there are keypoints that provide a roadmap to the areas where we might see reforms and institutional changes, and then sets out the short, medium and long-term investment implications of these changes (see Table 1). We highlight the main ones below:
Security cooperation and infrastructure are the two areas that might benefit from a marked and extended step-up in spending. An increase in EU defense spending would benefit highly skilled small and medium-sized enterprises (SMEs) in the medium term, as well as R&D in cybersecurity.
Investment in technology and high value-added sectors will help the EU regain competitiveness. Energy and transportation could also benefit from higher infrastructure spending in the long run.
The stability safeguards of the Economic and Monetary Union (EMU) have improved. Financial system reforms implemented since the crisis combined with better fiscal and external balances should in principle have lowered periphery risk. However, as the ECB moves toward tapering, i.e. a less accommodative monetary policy, and as financial conditions tighten, this hypothesis may be tested.
A resilient banking system will be key to ensuring continued Eurozone recovery and longer-term stability. Bank securities should be bolstered by further banking union reforms and a continued, albeit gradual reduction in non-performing loans (NPL).
A move toward deeper mutualization of financial risks in the Eurozone will continue to face significant political resistance, at least until further fundamental reforms have been made on a national level. Yet stronger fiscal discipline, combined with a somewhat larger common budget and, possibly, a joint funding capacity, would help to reduce sovereign risk and support peripheral bonds in the long term.
Nationally, further structural reforms and labor market reforms in particular are currently ongoing in France and should benefit labor-intensive companies in the medium term, with the manufacturing sector also likely to gain from renewed flexibility in employment supply.
While political risk has diminished regarding euro cohesion, in the short term, Italy remains the key risk to monitor ahead of the 2018 general election. Market stress could increase toward the end of the year, with BTPs coming onto the market radar again. Political instability, while not endangering the future of the euro area, could delay domestic structural reforms and, as a result, the performance of Italian assets.
Sandrine Perret & Krithika Subramanian – Investment Strategist – Credit Suisse
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