Will political uncertainty upset the European recovery?

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One of our key convictions at the start of the year was that there would be a degree of convergence between the growth rates of the US and European economies. As the sugar high of generous fiscal handouts faded, and pandemic-related savings were depleted, we expected US growth to slow. In contrast, in Europe we expected activity to accelerate as the cost-of-living shock finally faded, giving consumers confidence to finally spend some of their pandemic savings.

A turn in the global trade cycle was also supposed to support the European manufacturing sector, which has been stuck in the doldrums for the past two years. The key question I am asking myself this month is whether the UK and French elections could interfere with this narrative?

In the UK, the polls point to a change of government and a large Labour Party majority once the votes are cast on 4 July. The fiscal implications of such a result are not yet clear. Historically, Labour governments have been bigger spenders than Conservative governments. However, for numerous structural reasons, not least the cost of supporting an ageing population, UK government spending as a percentage of GDP is already very high, as is the tax take.

The Labour Party’s commitment in its manifesto to have debt falling as a percentage of GDP over the course of the five-year parliament means that more generous spending by a Labour government will be difficult without significant tax increases. However, with increases in income tax, national insurance and VAT also ruled out, Labour’s spending ambitions would be expected to be somewhat constrained. 

If elected, the incoming Chancellor of the Exchequer, will also live in the shadow of the Liz Truss mini budget crisis. Which means any unfunded spending pledges are unlikely in the short term. 

It could be that a new UK government might provide a boost to confidence if it is perceived to be more stable than the previous government proved to be, with multiple changes of prime minister and senior cabinet members in the last few years. In which case, the UK election could further support rising confidence already underway. Who knows, maybe even England’s performance in the Euros will help…ok, perhaps this is a stretch too far!

Across the Channel, the French National Assembly elections will conclude shortly after the UK election, on 7 July. Current polls suggest President Macron will have to form a coalition with either the far-right Reassemblement National, or the far-left La France Insoumise, and appoint the leader of that party as his prime minister. 

This prospect had caused much volatility in European markets since the election was called. It is important to realise, however, that neither of these more populist parties are calling for France to leave the European Union or the euro. The common threads among the parties that gained support in the recent European elections are anti-immigration and a scaling back of austerity. The risk this time around is fiscal risk rather than break up risk, so we do not believe we should see contagion to other countries, such as Italy and Spain.  

Whether either a victory for the far left or far right leads to a much more aggressive fiscal agenda in France is not certain. It is relatively easy to make big pledges when you are a populist opposition party that does not expect to actually govern. The reality when in office is quite different, and those pledges have to be funded by international bond investors. We have already seen a more toned down set of ambitions from Reassemblement National since the election was called. The pension reform is to be adjusted rather than abolished, for example. 

Italian prime minister, Giorgia Meloni, who was also from what was once considered to be a populist party, has brought a degree of stability to the Italian government. Prior to the European elections and the recent French political concerns, Italian bonds were trading at a record tight spread relative to German Bunds. 

Overall, therefore, I suspect the market is currently unnecessarily concerned. I do not expect European elections to derail the European recovery. 

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