#MacroMemo: May 8 – 12, 2017

French political update:

• The French Presidential election ended as expected, with centrist Macron claiming the Presidency over populist Le Pen.
• This was in line with expectations, though the margin of victory – roughly 30 points – was larger than predicted.
• Next on the itinerary are the country’s two rounds of Assembly elections in June.
• The fact that turnout was low and spoiled ballots high (9%!) suggests Macron’s victory was not so much a function of his personal popularity as a lack of other palatable options.
• This hints that Macron’s fledgling “En Marche!” party may have a tougher time of it come June. We believe the party will capture the most seats, but fall short of an outright majority. This, in turn, will necessitate cooperation with other centrist parties and could limit the extent of legislation delivered.
• Macron’s key policy goals include improving relations within the EU, productivity-enhancing labour market reforms (that threaten a surge of strike actions) and competitiveness-enhancing corporate tax cuts.
• As per our expectation, the story of European elections this year has been a welcome one of centrists besting populists. The German election in the fall is unlikely to change that narrative. The Italian election due no later than next year could yet prove the spoiler, though even there the Five Star populist movement recently slipped back into second place in the polls.

Eurozone breakup risk:

• As European political risks ebb and flow, it is important to map this onto the risk of a Eurozone breakup given that many populist parties seek this outcome. For that matter, a Eurozone breakup is also inadvertently possible if public debt trends or bank balance sheets trend in the wrong direction for long enough.
• Across much of 2016 we argued there was a 30% chance that a Eurozone country would initiate its exit from the Eurozone at some point over the next five years. Given the run of good election outcomes in 2017, we now downgrade that risk to 25%.

Providing other takes on this risk:

• A Sentix poll now suggests a 14% risk of Eurozone breakup over the next year, down from 25% just a few months ago, 49% at the peak of Greek referendum worries in 2015 and a mind-bending 73% in 2012 during the European sovereign debt crisis.
• On the other hand, the Italian-German 10-year spread has doubled over the past few years, suggesting no let-up of risk in that country. Admittedly, this spread captures more than just Eurozone breakup fears, and Italy is not the average European nation.
• As for the consequences of a Eurozone breakup, this varies considerably depending on whether the subject is a full dissolution of the Eurozone or merely a single nation exiting.

Full breakup:

• Estimates vary from a 5% hit to European GDP, all the way to a massive -25% disaster. The latter takes grim inspiration from the economic toll paid by countries exiting the Soviet Bloc.
• The pain has less to do with the sudden imposition of trade or currency barriers, and far more to do with the threat of widespread debt defaults and resulting financial market contagion.
• Our sense is that a 5% to 10% underperformance by the European economy is the most reasonable guess, with perhaps a 3% to 4% hit to global growth via a mix of compositional and contagion factors.
• Of course, individual countries – particularly those in southern Europe – could be hit much harder.

Partial breakup:

• A partial breakup would be considerably less costly, perhaps on the order of one-third the pain for the exiting country and one-fifth to one-eighth the pain for other economic actors.
• That said, some argue that the contagion effect from a single country exiting the Eurozone could be enough to bring the entire union to its knees, rendering the partial breakup analysis moot.
• The proper conclusion to these ruminations is that a Eurozone breakup has become less likely than it was just a few months ago. Moreover, it isn’t especially likely in an absolute sense. However, the risk is not entirely trivial and the consequences are sufficiently outsized that the risk needs to be regularly monitored. At present, a simple calculation suggests it reduces the expected rate of global economic growth by around 0.25ppt per year (though, in reality, it is a Boolean condition: it will either reduce growth much more severely, or not at all).

Event review:

• The Fed seemingly remains wedded to its tightening schedule, signaling last week that recent economic weakness is ephemeral and that additional rate hikes are likely. We are inclined to think that the urgency to raise rates has diminished slightly, but not to the point of taking full rate hikes off the table.
• U.S. payrolls managed to unwind March weakness with a good-looking April print of +211K, solid wage growth and an unemployment rate that again defied expectations by falling to just 4.4%. Other labour market peripherals also remain healthy. This is important not only because of its timeliness but because it is a piece of “hard” economic data that points to strength. So far, most economic strength has come through rather woolier confidence data.
• A U.S. health care bill managed to survive the House of Representatives after several earlier false starts, though it is far from assured that the Senate will also pass the piece of legislation. For now, it raises the likelihood that Obamacare will be partially dismantled and arguably delays the implementation of tax reform.
• Canadian employment finally missed expectations after months of beating them. The country generated only 3K jobs in April and the composition was atrocious: full-time employment fell by 31K and private employment was 50K lower. Furthermore, wage growth now sits at the bottom of a well (+0.5% YoY for permanent workers), the lowest in decades. We hesitate to sound the alarm given that hours worked rose decently over the past year and several heroic months lie not too far in the rear-view mirror. Other metrics of economic activity for Canada remain good.

Data preview:

• A heavy Fed week: This week is chock-a-block with Fed speakers. Already, former Fed governor Warsh has laid out his vision for how the Fed should act, central among them that the Fed’s balance sheet should be worked down before rate hikes occur. Given that he is believed to be in the running to replace Chair Yellen next year, those thoughts are worth listening to. As to the other upcoming speakers, we wonder whether they will partially walk back the Fed’s seemingly status-quo assessment last week, leaving open the possibility for a slower pace of tightening.
• U.S. CPI ahead: April should manage a partial reversal of the inflation weakness that dominated March, though not to the extent of increasing the annual inflation readings from approximately normal 2%-esque levels in the U.S.

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