By Greenwood Investors
Europe is the world’s consensus short. One need not look too hard to find news stories about the instability of governments all over the continent, rising populist movements and “stagnant,” economies. This view has been well honed by economists, thought leaders and the global “elite.” In the run-up to and in the wake of the Italian referendum, there have been innumerable attempts by Wall Street commentators to talk about the “next domino” to fall and how a failure of the Renzi government to convince the Italian population of the need to reform would cause imminent doom and gloom. These views were well-baked into market expectations, which is why in the wake of the “worst case scenario,” outcome in the Italian referendum, European markets have actually rallied – including Italy’s. Of course fluid political environments are nothing new for Italy, having had now 66 governments since the end of World War II. In fact, Italians have shown a predictable skepticism against increasing the strength of the government, with Berlusconi’s similar electoral reforms defeated by nearly the exact same margin as Renzi’s political reforms exactly a decade later. With President Mattarella asking Paolo Gentiloni to form a new government under the same electoral coalition that Matteo Renzi relied upon, it looks to us that within a matter of a few weeks and some fresh capital injections into a couple of weaker Italian banks, Italy will soon return back to business as usual rather than the nightmare political vacuum markets had priced-in.
In the wake of Donald Trump’s surprise election in the United States, investors have concluded that similar anti-immigrant populists everywhere will win elections and disrupt economic progress. Marine Le Pen, the leader of France’s National Front, may steal a lot of headlines with her promise to hold a referendum on France’s membership to the eurozone, but these headlines are simply a sideshow to recent political developments which have seen Francois Fillon to emerge as her top contender, a candidate whose policies look much more similar to Trump’s than any other in France. And he’s not just a top contender, but has opened up a commanding 32% lead in recent polls. While polls have become less reliable lately, a lead this large is well outside any heightened margin for error. Yet despite these polls, populist parties in Europe have stolen most of the headlines which has catalyzed a herd-like withdrawal of international investors from European equities.
Exhibit 1: Weekly European Equity Fund Flows ($ in billions)
Source: DB, EPFR
The world remains significantly underweight peripheral European securities at a time when easy monetary policy is keeping heavy pressure on the euro foreign exchange rate, which has been a boon for international European companies. This increase in competitiveness relative to their US counterparts will only continue to widen as the European Central Bank has committed to more Quantitative Easing for a longer period while the US Federal Reserve is poised to continue raising rates throughout 2017. This will continue to be a major theme for the year ahead as Europe goes through its own electoral season.
Exhibit 2: Cumulative Equity Fund Flows in the Last 12 Months
Source: DB, EPFR
While the populist parties in Europe (who typically make the most outlandish, and headline-grabbing statements) occupy the majority of newspaper headlines and investor attention, a more quiet and conciliatory free market slate of candidates stand poised to win this vital electoral season. France’s Fillon has a free-market agenda that would unlock a stagnant French economy by reducing regulations, promoting longer work weeks, lowering entitlements, reducing the importance of unions, and lowering French government spending outside of defense. Proposed policies include a reduction in numerous taxes, including corporate taxes, and a complete re-writing of labor laws. Yet the market is largely unaware of such a positive outcome being remotely close to possible. As such, as polls currently predict a landslide run-off election in which Fillon will likely become the next President of the Republic, the French market is set for a far more dramatic response to such a win than that of the US market in the wake of Donald Trump’s election. The major difference is that Fillon will be inheriting an economy that has been subjected to nearly a decade of economic stagnation as more regulation, lower incentives to work and high government entitlements have held back economic activity far below potential normalized levels.
Exhibit 3: Expectations vs. Reality in France’s Upcoming Presidential Election
Source: GreenWood Estimates based on qualitative and quantitative factors.
Thus, while the market is currently expecting a high risk of a protectionist or anti-free-market outcome in France, the recent polls published since Fillon’s win of the Republican primary have suggested that the Presidency is in the bag for the free-market candidate. Almost reliably all year, the market has mid-judged outcomes relative to the underlying reality. We understand polls have been terribly wrong, but the market has even misjudged the outcomes of the outcomes. For traders focused on making short-term profits, this has been an incredibly taxing and difficult year, with unexpected outcomes happening repeatedly. While the juxtaposition of Fillon relative to outgoing President Hollande is less dramatic than the Argentinian example, we believe a Fillon win for the country would be akin to the assumption of the Presidency by Macri from Kirchner in Argentina’s 2015 elections. While less of a boon for free-market and economic policy, Brazil’s impeachment of its President and later assumption of the office by the Vice President represented another positive political step for a country that has been running far below economic potential. These two examples are actually important because both markets were among the worst performing global indices in 2014 and 2015, particularly in dollar-based measurements. They both have become the top performers of 2016, but the market’s positive returns didn’t wait for the new candidates to assume office, as the markets climbed in anticipation of a more favorable resolution in both cases.
Exhibit 4: Market Returns Around Elections & New Governments
Data Source: CapitalIQ
Both the Argentine and Brazilian elections and market developments give us cautious optimism going into the European electoral season. Despite Italians voting against Prime Minister Renzi’s proposed electoral reforms, Italy’s anti-European party, the 5 Star Movement, has not gained popularity in the country in recent months. In fact, most Wall Street “strategists,” were simply incorrect in rushing to judgement and claiming that the defeat of the reform will help 5 Star Movement seize control of government eventually. The rejection of the electoral reforms has allowed the President to request the next Prime Minster find a coalition to support the re-writing of the electoral law, and the country’s constitutional court will opine on a controversial still-standing super-majority component to the Renzi reform on January 24. The honest truth is