The eurozone – risk in France and hope from Germany
As 2024 draws to a close, it’s no exaggeration to say that it has not been very favourable for European equities. As the S&P 500, the US stock market’s flagship index, storms ahead, up 27%, and even 33% for a euro investor thanks to dollar appreciation versus the single currency, the EuroStoxx 50 has risen just 5%[1]. The reasons for this underperformance are well documented – French political instability, industrial activity in the doldrums, and many companies with exposure to the underpowered Chinese economy. We now need to consider the future outlook. Of course – and to a degree, unfortunately – the destiny of the eurozone will depend on China’s ability to finally jump start its economy and the Trump administration’s strategy raising on import tariffs, but it is also likely to be driven by the vagaries of its two motors: France and Germany.
For France, further slippage is the predominant risk. Political instability will certainly continue for several months to come. The likelihood of an imminent fall of the Barnier government is growing, and if that happens, nothing is off the table, including the resignation of President Macron. Such a situation would only further strengthen investor mistrust. What’s more, even if the budget is passed and there isn’t a vote of no confidence, the impact would undoubtedly be only slightly positive, given the prospect of parliament being dissolved once again next summer, meaning that the government will remain unstable.
In addition, on top of the purely political issue, the fiscal question will remain central. And if the budget does pass, this would only bring the deficit down to 5% of GDP, which is still very high in absolute terms. Besides, this calculation is based on the assumption, contained in the Finance Act, of GDP growth of 1.1% in 2025, which has very little chance of being achieved, given the recent direction of economic indicators. Growth of 0.5-0.7% looks more credible, with a real risk of technical recession during the year. A budget based on overly optimistic growth assumptions will only lead to further slippage. And sadly, the French situation is neither new nor exceptional. France has breached the deficit threshold of 3% of GDP more often than any other country since the creation of the eurozone – in 20 years out of 26. Furthermore, today it has the worst public deficit/debt ratio of all countries in the monetary union: Italy and Greece have a higher debt/GDP ratio than France, but in 2024, Italy’s budget is more or less balanced, and Greece has a clear surplus.
Despite this less than glorious situation and French 10-year rates recently rising above those of Greece, France continues to be able to borrow at modest rates. But today there is a real risk that continued budgetary recklessness combined with political instability will eventually result in such lack if confidence that rates will spike in markets and France will be plunged into a sort of debt crisis, albeit one of modest proportions. This is undoubtedly the major risk for the eurozone in the coming quarters.
However, this risk is offset by hopes for Germany after the rupture of the coalition in power. Barring any major turnaround, the CDU/CSU led by Friedrich Merz is likely to emerge as the leading party in the resulting early Federal elections in February next year. As prospective future Chancellor, he will then have to form an alliance either with the SPD of Olaf Scholz, or with the Greens, depending on their respective scores. Whatever the colour of the next coalition, it seems certain that Germany, which has real room for manoeuvre with a debt/GDP ratio of just 59% and no primary deficit, will finally relax its fiscal orthodoxy. It has three credible paths available. Firstly, to loosen the terms and more frequently activate the escape clause that enables the Bundestag to suspend the debt brake, “in the event of natural catastrophes or other exceptional emergencies outside of the government’s control[2]”. Secondly, to reintroduce the special EUR 100 billion fund created in 2022 to support the defence budget, or to create a new one. Thirdly, to review the budget deficit limit included in the debt brake. It is currently set at 0.35% of GDP and could be raised to 0.5% or even 0.75%.
These adjustments may appear minor. However, they would represent a major development in the mindset of the German government, and at present it is hardly credible to hope for more in the short term. In terms of investors’ risk perception, this could prove a breath of fresh air, the eurozone’s largest economy finally taking the measure of an economic model that has been in decline for close to a decade and showing itself capable of introducing a little flexibility to its sometimes fanatical ordoliberalism. It could also provide a boost for certain cyclical sectors that have been neglected by the market, such as cars and chemicals.
The fate of the eurozone stock market in 2025 will depend in no small part on the outcome of the dangerous situation brewing in France on the one hand, and of the (reasonably) hopeful situation in Germany on the other.
Final version of 29 November 2024 – Enguerrand Artaz, Fund Manager, LFDE