Electile dysfunction
Electile
Dysfunction
A curious mix of election results and announcements over the past month, has brought political risk back to the minds of investors. Parliamentary elections called by UK Prime Minister Sunak and French President Macron, are likely to see one of them lose their job in coming weeks.
The French election brings a heightened risk of a parliament split between right and left-wing, with populists on both wings offering fiscally incontinent policies that could result in even higher public deficits and bond yields.
US economic data has softened in recent months, with more data coming in below forecasts. This has contributed to lower bond yields in recent weeks as slower economic growth is seen as opening the door to the Federal Reserve cutting interest rates.
Company profits are coming in better than expected and feeding through to analysts raising their profit forecasts for 2025. Despite equity valuations remaining elevated, rising profits should allow equity markets to weather higher-for-longer interest rates, until the point that the slowing economy morphs into a recessionary one, if indeed it arrives.
How political risk evolves may determine investor appetite over the next month. More often than not equity markets (and investors) adapt to the changing political environment, and that is the path that we expect with respect to the UK. Only when significant change is attempted (i.e. the Truss budget) do markets tend to react. How France votes may matter over the next few weeks, and looking forward to the November 2024 US Presidential election, the potential return of the now convicted felon Donald Trump may temper investor appetite towards US assets.
Poll dancing
Recent election results in India, Mexico and South Africa have had a mixed reception from investors. India has seen a recovery despite an initial setback after the Modi led government lost its majority, whereas Mexico and South Africa have seen market falls since election day. Mexico is down over 10% since the result which saw the nationalist party’s majority grow, prompting concerns over constitutional changes.
The European elections at the start of June saw the ‘far-right’ share of the vote rise in France, Italy and Germany. In Germany, the Alternative for Germany party came second, and in Italy the Brothers of Italy party increased their share of the vote. Whilst the right increased their share of the vote, the centrist party coalition will remain in power in the European Parliament.
Interestingly, the Green parties across Europe saw a sharp fall in their seats from 71 to 52, suggesting that the cost of living crisis endured since the last European elections has seen a reassessment of the Green agenda.
The French result triggered Macron to call a surprise parliamentary election. He has vowed to stay on as President even if his party loses the election, but the risk of a far-right party gaining power in France has seen equity markets fall in Europe. The prospect of a right-wing coalition of RN (Rassemblement National), led by Marine Le Pen, and Les Republicans governing runs the risk of a Truss-like unfunded spending plan being enacted.
Somewhat worryingly for Macron, the left-wing have aligned as a coalition (meaning they will run a single candidate), which leaves the President’s own party somewhat stranded in the middle and at risk of being squeezed out. The first round of voting in France will take place on the 30th of June, and polls suggest that the RN will take 35% of the vote, which may see them become the largest party in the Assembly, but short of an overall majority. The uncertainty resulting from the election call has resulted in a 7% decline in French equities in just one week and weakness across European equities.
Splitting fiscal hairs
In the UK, we have seen election manifestos launched, but the lack of ambition contained within indicates the realistic state of the UK’s public finances and the challenges that remain post-austerity, Brexit and Covid. The manifestos suggest that the overall fiscal difference between the two main parties is quite slight. Other parties with no realistic chance of victory are less constrained by reality in their promises.
It is likely that taxes will rise and some public spending will continue to be cut, whichever party wins the election, as the impact of a sluggish economy and spending pledges (in the form of defence and pensions) need to be catered for.
We suspect that a period of strong and stable government in the UK will be welcomed by the many but maybe not by the few. Brexit and immigration are the elephants in the electoral room that the two major parties appear to be reticent to discuss, which leaves the populist (not necessarily popular), Farage to exploit tensions against a backdrop of stagnant living standards and strained public services.
100 years on…history doesn’t repeat but it does rhyme
The 2024 UK election offers the prospect of the Conservative Party losing hundreds of seats, and potentially having less than 100 seats in the new Parliament. Something similar happened to the Liberal Party in 1924. The Liberals had initially supported the minority Labour Government led by Ramsey MacDonald that had been in Government since the January of 1924. In the October 1924 election, the Liberals lost 118 seats and their share of the vote fell from 30% to 18%. The Liberals had traditionally been one of the parties of Government through the 19th Century and early 20th Century. Post-1924, they did not recover political power until the Coalition government of 2010-15, after which they lost 48 of their 56 seats in Parliament. The current Conservative Party may be facing a wipeout of 1924 proportions.
Will Reform water the seeds of the Conservatives downfall, as those seeking the sunlit uplands of Brexit find a home in the offerings of Farage?
The first cut is the deepest
In Europe and the US, inflation remains above the respective central banks’ target levels. Despite elevated inflation, the European Central Bank (ECB) cut interest rates at the beginning of June. At the subsequent press conference, the ECB President suggested that they would delay until they were comfortable that inflation would fall further before reducing interest rates again.
The Federal Reserve updated the market with its outlook on the 12th of June. They raised the inflation forecasts for 2024 and indicated that they think interest rates will be cut ‘only’ once, by 0.25% in 2024. This compares to the Federal Reserve forecast at the March 2024 meeting of three cuts in 2024. Markets continue to expect more than one rate cut from the Federal Reserve, so hope springs eternal.
July 2024 will see a year since the last interest rate increase in the US. The Federal Reserve increased rates by 5 percentage points and these rate rises have slowed the economy. However, they have probably had less impact than the Federal Reserve would have modelled on both economic activity and inflation, both of which remain somewhat higher than forecasts made in 2023. In Summer 2023, consensus expectations for economic growth for 2024 hovered around 0.6%, while economists now expect economic growth of 2.4%, albeit these upward revisions have stalled in recent months. Inflation forecasts have increased from 2.5% to over 3%.
In the UK, inflation fell to 2% year-on-year according to the data on the 19th of June. The Bank of England is expected to maintain the current level of interest rates until August. Inflationary pressure is easing but wage growth remains elevated. In the UK, wage inflation has eased, but not to the same extent as in Europe and the US. Indeed, the global recruitment company, track pay offers via their recruitment activity. UK employers are offering higher wage growth than in other countries. This pattern is being seen in the ‘official’ economic data, where the wage component of inflation remains higher in the UK than in Europe and the US.
This may be a consequence of the rise in the ‘living’ or minimum wage enacted by the current government. Set at 9.8% the minimum wage increase may also be lifting wages of workers higher up the pay scale.
The Indeed Wage tracker reflects the wage growth of job postings: it suggests that wage inflation remains quite elevated in the UK
Source: Bloomberg, Artorius
Big is best, even in Europe
The equity market has been very tolerant of the delay in monetary policy easing in 2024. Whilst US economic growth has been stronger than expected in 2024, European and UK economic data has remained poor. Perhaps the surprise of 2024 hasn’t been the robust returns of US equities, but that the returns were delivered by the largest 50 Euro area equities. European equities had delivered 11% returns (in Sterling terms) up until the end of May, similar to US equity market returns. The French election call has seen some of that performance ease back in recent days, but a weak economic backdrop in Europe hasn’t prevented robust performance from the very largest European companies.
The contrast between big and small has been raked over in the US but also appears to be showing up in Europe and the UK. In the US the dominance of a few large technology companies is used to explain the divergence in performance between large and small companies, but in the UK and Europe the reasons appear much more stock specific. In Europe, Novo Nordisk has risen 33% in 2024 and the Dutch ASML has rallied 28%. The third largest European stock Nestle has fallen 3%. Other large companies exposed to the luxury consumer have fared poorly as well. LVMH and L’Oreal rising by less than 2% in 2024. Even the banking sectors have enjoyed stirring returns, despite the lacklustre lending environment.
In both Europe and the US, large-cap stocks are comprehensively outperforming their small-cap cousins
Source: Bloomberg, Artorius
Source: Bloomberg, Artorius
In the UK, the largest companies have done well, with the top 7 stocks all rising strongly. Similar to Europe, the banks such as Lloyds and Barclays enjoyed stellar returns in 2024.
The gap in performance between the large and small companies may be symptomatic of relative caution by investors given the lack of economic growth - a key driver to revenue and profits. Given that smaller companies tend to currently trade on attractive valuations, were the cost of finance to fall (i.e. if interest rates were cut), then one may see a rise in mergers and acquisitions taking advantage of the gap in valuations between big and small. But with interest rates remaining higher for longer and political uncertainty, we may have to wait before corporates and private equity investors become a force for driving equity market returns for smaller companies.
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Conclusion
Political commentary is running hot. The elections in France and the UK offer the potential for new governments. In the UK, the actual fiscal difference appears to be slight when the manifestos are compared, with both parties locked in by the state of the public finances.
In France the prospect of the centrist party of President Macron being squeezed out by the radical right and left-wing parties may result in unpalatable fiscal considerations. Populists are offering policies that would result in even higher public deficits. How this would be funded in an era of elevated interest rates is one that is percolating through asset prices, resulting in higher bond yields and lower equity prices.
Company profits are coming in better than expected and feeding through to analysts raising their profit forecasts for 2025. Despite equity valuations remaining elevated, rising profits should allow equity markets to weather higher-for-longer interest rates, until the point that the slowing economy morphs into a recessionary one, if indeed it arrives.
How political risk evolves may determine investor appetite over the next month. More often than not, equity markets (and investors) adapt to the changing political environment, and this is the path that we expect with respect to the UK. Only when significant change is attempted (i.e. the Truss budget), do markets tend to react. How France votes may matter over the next few weeks, and looking forward to the November 2024 US Presidential election, the potential return of the now convicted felon Donald Trump may temper investor appetite towards US assets.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 21st June 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
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