As Political Risk Fades, Are European Equities Poised to Break Out?

French voters did far more than elect a new president on Sunday. They may have helped restore European Union (EU) stability and set the euro zone on a decidedly more stable course, although French parliamentary elections next month and Italian elections next year are likely to keep investors on their toes.

Centrist Emmanuel Macron won 66% of the vote in the run off, compared with anti-EU candidate Marine Le Pen who won 34% of the vote. Macron’s victory helps lift a political cloud that had been hanging over the future of Europe, particularly since last summer’s Brexit vote placed the UK on a path out of the 28-nation EU. With France now solidly anchored to the EU and the euro-area common currency, many investors are optimistic about the outlook for European markets and the economy – for the first time in a long time.

Tailwinds Gathering

“My view is, this election is a pivot point – a true catalyst – that could position Europe, certainly in the near term, as a more attractive place to invest,” says Andrew Suzman, an equity portfolio manager with Capital Group. “To be clear, challenges remain in Europe, and this election will not solve all problems, but valuations are, in many cases, very low and a major political and economic disruption has been avoided.”

The French election result is adding to a growing list of tailwinds gathering in support of European markets. They include: signs of improving economic growth, attractive equity valuations compared with other developed markets, and a gradually depreciating U.S. dollar. The dollar’s sharp rise since 2014 has hurt European-asset returns for dollar-based investors.

Heading into Sunday’s election, markets were already anticipating a favorable outcome. French equities rose 3% in April, compared with a 1.5% gain for the MSCI World Index. On a year-to-date basis, the MSCI Europe Index is up nearly 8% in local-currency terms and more than 11% in dollar terms, as of April 30, 2017.

Additionally, the euro rose to a five-month high against the dollar in late April as Macron soared far ahead of Le Pen in the polls. As the leader of the far-right, National Front party, Le Pen had pledged to take France out of the EU, revive the franc as the national currency, and impose strict limitations on immigration. Macron, meanwhile, is a centrist, pro-EU advocate who has pledged to bring economic and political reforms to France while working cooperatively with Brussels and Berlin.

“Europe will welcome President Macron, and Germany is positively disposed to work with him,” says Talha Khan, a political economist at Capital Group. “Macron’s election will help reset the FrancoGerman relationship, which is at the heart of the EU. In a sense, Europe is Macron’s biggest opportunity. If he can convince Germany to do more to solve the economic imbalances in lieu of France’s commitment to reform, it will be very positive for the long-term outlook on the European economy.”

Return to Fundamentals

Capital Group economist Robert Lind agrees, adding that a more stable political environment will allow investors to put aside the EU break-up risk and focus on more traditional considerations. “Fading political uncertainty has finally enabled investors to concentrate on what’s important – the underlying fundamentals,” Lind says. “Companies in the euro zone are seeing a significant improvement in earnings growth, which reflects a stronger macroeconomic environment. After a protracted period of underperformance, there is scope for further relative gains in euro-zone stocks.”

Still, many of France’s largest publicly traded companies long-ago learned not to rely on the sluggish French economy to act as a tailwind. Companies such as Airbus, L’Oréal, LVMH , Sanofi and Total are global enterprises that look to the U.S. and Asia, in addition to western and eastern Europe, for earnings growth opportunities, Lind notes.

European Revival

Bond investors should also feel the impact of Macron’s victory as the yield spread narrows between French and German government bonds. French yields had widened significantly in the weeks ahead of the French election, reflecting fears that France might abandon the euro. Post-election, some investors now expect the European Central Bank to begin reducing its economic stimulus program later this year, or early next, and perhaps consider raising interest rates in 2018.

“The next 10 years will potentially be known in the history books as something like the ‘European revival period’,” says Thomas Høgh, a fixed income portfolio manager at Capital Group. “Under what I consider reasonable assumptions, the EU should remain together and develop further towards a federalist system of government. The appeal of populist parties should diminish as unemployment rates come down and the fruits of economic reforms begin to show up.”