Pro-Europe sentiment is good news for investors

The election of president Emmanuel Macron in France last spring increased the odds of a unified European economic policy.

He has expressed interest in moving to pan-European fiscal policy measures, eventually leading to pooling debt across countries under a common finance minister.

The events of recent weeks have nudged the region in this direction. Developments in Italy and Spain – the third and fourth-largest eurozone economies – signal that more European governments may move toward a common economic policy. There are also signs that Germany, the bloc’s economic giant, may soon have a pro-Europe coalition government.

For global investors, a more unified Europe may be the single most important development of the next five years. With regional growth accelerating as separatist forces weaken, investors should expect an appreciating euro and rising equity valuations. For multinational corporations, policy coordination across European nations should make for a larger, and more dependable, market of consumers.

Europe’s competitiveness was boosted last week by the agreement between the leaderships of German Chancellor Angela Merkel’s Christian Democrat Party and the Social Democrat Party to form a coalition government. The Social Democrats, known for pro-Europe views, will name the finance and foreign ministers.

Olaf Scholz, mayor of Hamburg, will lead the finance ministry, considered to be the second-most important position in the cabinet. The finance minister is also the key link with the rest of Europe. Mr Scholz has indicated that Germany will no longer dictate details of economic policy to its neighbours as his predecessor had done. This switch should create a more congenial atmosphere for talks.

In Italy, Luigi Di Maio, leader of the anti-euro Five Star Movement that is leading in the polls ahead of the March 4 elections, has relegated plans for a referendum on exiting the eurozone to a “last resort”. Speaking in London on Janusry 31, he expressed interest in attracting foreign investors by making it easier for Italian banks to recover assets from troubled borrowers, a move that would be welcomed by global private equity and hedge funds.

Mr Di Maio also addressed the possibility that no party gained a majority in next month’s elections. In that case, he indicated that he would be open to joining a coalition government to avoid a hung parliament requiring fresh elections. All of these moves suggest that Italy may be more aligned to co-operating with the rest of Europe than it has been for several years.

Spain’s prospects have been boosted by an economy that expanded faster than 3 per cent in 2016 and again in 2017, posting the highest growth among the eurozone’s four largest economies. On the political front, the risk that the Catalonia region will secede from the rest of the country has faded. That ends a major distraction for the administration of prime minister Mariano Rajoy, and removes a major stumbling block to Spain working toward economic integration.

European bond markets are reflecting the reduced sovereign risk in Italy and Spain relative to Germany that provides the region’s measure of “risk-free” yield. Over the past six months, the spread between the yields on Italian and German 10-year sovereign securities shrank from 158 basis points to 130 basis points, and the Spain-Germany spread narrowed from 100 basis points to 73 basis points.

Despite the message from the bond markets, the promise that a unified Europe holds for investors is still not widely discounted in markets. Valuations of equities and the euro have yet to take the positive developments into account. For example, the Stoxx Europe 50 equity index fell more than the principal US equity indexes in percentage terms during the week of February 5. The euro weakened from $1.245 at the beginning of the week to $1.225 on February 9.

This is traceable to remaining potential setbacks to a rapid European integration. In Germany, the Social Democrat leader Martin Schulz, a former president of the European Parliament, decided to give up his claim to become foreign minister on February 9 after an intraparty squabble. Also, the deal Mr Schulz reached with Mrs Merkel has to be approved by the rank and file of the SDP.

In Italy, the new government will focus on consolidating power after the elections rather than immediately work toward a common European economic policy.

Such short-term hurdles should not obscure the promise for investors with a longer time horizon: the eurozone has become an attractive value play with the prospect of higher equity prices, bond yields narrowing further toward German levels, with currency appreciation as the icing on the cake.