Macron and a new Europe

Mario Draghi could not eliminate the risk of a breakup of the euro or the EU driven not by financial markets but by populist politics, in the style of Brexit and the election of Donald Trump in the U.S. Investors have, therefore, been understandably nervous about committing big money to Europe.

The decisive outcome of the French presidential election has now removed the tail-risk of “Frexit” and should radically improve economic and financial conditions throughout Europe before the end of this year. The biggest financial benefits of Macron’s election may not even be felt in France but in the EU’s “periphery” countries — Italy, Portugal and Greece and, in a different way, Britain.

While the short-term, market reaction may be to “sell the news” after last week’s “buy the rumour”, long-term investors should use any short-term dips to increase their exposure to euros, European equities and especially to the banks and bond markets of peripheral euro countries such as Italy, Spain and Greece. Italy and other “Club Med” countries can expect both domestic and external benefits from Macron’s election. Externally, his presidency is almost certain to i mprove Franco-German relations and the management of the eurozone.

With the EU threatened as never before by a “multi-crisis” of Brexit, Russian aggression, US indifference and Mediterranean refugee flows, Germany faces a clear and present danger to its national interest and its entire geopolitical strategy unless it eases the fiscal and regulatory stranglehold that has suffocated growth in the eurozone.

Angela Merkel surely understands this, even if her finance ministry, the Bundesbank, and many German voters do not. If Macron takes even the smallest symbolic steps to deregulate labour markets and undertake other supply-side reforms, Merkel will have the perfect excuse to start relaxing eurozone financial conditions — especially after Germany’s September 22 election, when resistance among voters to helping Mediterranean countries via a “transfer union” will no longer matter very much.

Internal politics in Italy, Spain and Greece will also benefit from the French election. An easing of German fiscal and regulatory pressures would allow Italy to resolve its banking problems by creating a publicly-financed bad bank. This would improve consumer and business confidence and could rapidly undermine support for populist anti-European parties inspired by the banking crisis.

More generally, as the global populist movement that seemed unstoppable after Trump and Brexit comes to a standstill, a loss of momentum seems certain for Italy’s 5Star Movement, Spain’s Podemos and the Syriza government in Greece. Combining these impacts on external and internal conditions, some of the biggest financial gains from Macron’s election are likely to be seen in the bond markets and banks of Italy and Greece.

Another indirect beneficiary of Macron’s election may be Britain and the sterling-dollar exchange rate. If a stronger

Spain, Franco-German relationship ends talk of a eurozone breakup and improves economic conditions in the single currency area, British voters will notice that the EU is growing faster than Britain and is not the moribund backwater they had assumed.

If the British economy continues to weaken under the pressure of Brexit, a majority of British voters may well decide in the next year or so that it is mistake to leave the EU. While Brexit will be unstoppable if Theresa May wins the greatly increased majority expected on June 8, Macron’s election suggests another possible option for 2019 and beyond.

With the eurozone consolidating under the new FrancoGerman leadership into a fiscal union, the EU members that remain outside the euro will need to develop new institutions and eventually enshrine these in new treaties and trading agreements.

For the single currency to survive in the long run, the EU will have to evolve into two closely related but distinct entities: an inside track heading to full-scale federation with jointly determined fiscal and monetary policies and common political institutions; and an outer ring consisting of independent countries that collaborate closely but do not share the objective of monetary, fiscal and political union.

As the EU evolves into this twin-track structure, which is bound to happen if Macron and Merkel want to make the euro work, countries such as Sweden, Denmark and Poland will not commit to full-scale political and monetary union. But once these countries make clear that they will never join the euro, the EU’s outer track will become very similar to the looser European Economic Area that also includes Norway, and the European Free Trade Area, which includes Switzerland too.

Although the British government has implied that Brexit will mean departure from the EEA and EFTA, as well as the EU, this has never been explicitly stated. A combination of EU institutional reforms and an improving European economy under rejuvenated Franco-German leadership, could create the conditions for Britain to remain in the EEA or EFTA after Brexit.

Therefore, investors in British assets should also pray for the success of President Macron.