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Europe, prime de risque

Italian elections of March 4 have delivered their verdict, and this is the commedia dell’arte. They are symptomatic of a trend that goes well beyond the transalpine framework.

Democratic lassitude

The extremes and the populists won more than 50% of the votes. All are clamoring for the keys to power, the traditional parties are shattered. This is not necessarily a surprise, in this country where it is so good to spend holidays, but that changes government once a year on average.

A trend

It has been a few years since the elections held in the European countries keep us in suspense. The rise of "anti-system" forces is impressive. Throughout the Union, the pro-capitalist left parties have been swept away, their electorate has melted, it is the case in France, Germany, Austria, Spain, and in many Eastern European countries. Now, the traditional center right is currently facing the same loss of confidence and is becoming radicalized. To win, the rights harden their speech and surf on the fears of their fellow citizens, like immigration, terrorism or digitization.

As we know, the trend is obviously not only European, as we have seen with Brexit and the election of Donald Trump. We could also mention Dutertre in the Philippines or Erdogan in Turkey; their coming to power or the evolution of the exercise of it is not very reassuring. While we are in a global and synchronized growth cycle, there is a democratic lassitude among the populations, which allows authoritarian personalities to achieve excellent results in polls.

Euro zone frailties

This evolution, although general in Western countries, entails greater risks for the Euro zone and the European construction. Indeed, the institutions of the region are fragile. The ECB through its president Mario Draghi can give the feeling that governance is good and that the European project is sustainable. It is true that bond purchases by the central bank, even if criticized for their long-term effects, have provided an important respite to the most fragile countries in the Eurozone. The credibility of the institution has calmed the financial markets and lowered the costs of financing public debt to levels so low that they were unimaginable just a few years ago.

Yet the Euro zone is still sorely lacking in governance. For the single currency to become sustainable in the same way as the dollar or the Swiss franc, there are still important steps to be taken. It is urgently necessary to introduce a European fiscal policy and a budget. Solidarity must be implemented; the richest states of the zone must provide support for the poorest. Thus, Germany must be more generous towards the countries of the south. Today Europe "costs" Germany 0.4% of its GDP if one looks at its net contribution. This is largely insufficient, because economic growth has not been and will not be homogeneous in the countries of the Eurozone. Worse, it is likely that disparities will increase between the north and the south, in the coming years since the best elements of the so-called “poor” regions emigrate to prosperous regions where prospects are better.

North-South divide

Moreover, if we look more closely, we can see that the mistrust towards the countries of the south of the Euro zone remains. By studying the intra-zone financial flows, which can be obtained via the Target2 statistics: we can see that Germany is in surplus of 882 billion Euro and that Spain is in shortfall of 399 billion as well as Italy for 433 billion (at the end of January 2018). These imbalances have only been accentuated in recent years, even though their growth rate has declined over the past two years. Should Italy default on its debt today, it would cost Germany about 150 billion euros, or just over 5% of GDP. We are obviously not there yet, but Europe is still heading there.

There are many European projects to start, principles of subsidiarity between the Member States and the Commission should be reviewed, a common defense policy, regulate tax competition and much more. Rome was not built in one day, yet time is running out. Now that Mrs Merkel has formed a government, one will look forward to the initiatives that will be taken with President Macron to relaunch the process of European integration.

A very fair discount

On the equity markets, the lack of long-term visibility implies an additional risk premium for equities in the euro zone compared to their US counterparts. It should also be added that the profitability is higher in the country of Uncle Sam. Thus, if we adjust the weight of the sectors, to compare apples with apples, the European discount is around 11.5% at the end of the month of February (Source: Thomson Financial). This is not far from the average of the past 15 years (8%). Given the long-term uncertainties weighing on European assets, it seems that this discount is quite reasonable. Therefore, without the fierce will of the Franco-German couple and the European Commission to strengthen cohesion, the valuation gap could well increase.

We are surprised that this aspect of valuations between the two zones is not mentioned more often. This is probably because it is not politically correct. Let's hope that the time that separates us from the next recession is still long, as since 2008, the populations of the euro zone have been tested and become fearful.

Favor US equities

In this context the Italian elections do not change anything. They simply remind us that time plays against inaction and that if nothing is done, we will have, in a not too distant day, a Euro-phobic leader in one of the founding countries of the Union who will himself be surrounded by other leaders very hostile to the Union, with a desire to retreat. In this case, the crisis that shook Europe in 2011 will resonate like an anecdote about what could happen then.

While waiting for encouraging announcements for more integration and solidarity from the European leaders, it is wise to favor American equities.

[1] Target2 is the real time gross settlement system. It operates on a single platform. Business relationships are established between the Target2 users and the respective central bank. A deficit is the portion of the current account deficit which is not counterbalanced by capital imports


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