Raymond James: Equity markets will suffer if Europe doesn’t act on economic reform

EU-Europe-Flags-Euro-700x450.jpgSo far this year, the story of Eurozone equities has been relatively straightforward: the more sanguine European investors were at the start of the year about the region avoiding political break-up and inflammatory election results, the more excess returns they are likely to have captured. And – as always with investments – confidence has grown as share prices or the Euro have gone up.

Unfortunately, the backdrop is changing. Continued cohesion across the Eurozone and a good transitional deal on Brexit are simply not enough to boost equity markets further. Nor is the willingness of the European Central Bank (ECB) to maintain its low interest rates and balance sheet stimulus. What European investments need now is economic reform.

Economic policies such as low interest rates and quantitative easing have a pretty clear scope to boost demand, in turn buoying economic growth and financial market prospects but the supply side, which offers a way of improving economic dynamism and efficiency, has been neglected. Government legislation, covering areas such as the flexibility of labour markets to boost job opportunities, encouragement of entrepreneurship and the raising of the education and training base have an important role to play. Yet outside of Germany, governments across the rest of Europe have been slow to adopt such initiatives, and hence their economies have struggled. If Europe wants to climb up from the lower rungs of the global economic growth and job creation ladder, then economic reform is a must.

Fortunately this all coincides with a large Parliamentary majority for the newly elected French President Emmanuel Macron. France has a highly influential position as a large, founding member of European co-ordination efforts since the 1950s, and a link between Germany and the struggling southern European countries. If France starts to pass economic reform measures, others will be encouraged to follow.

And encouragement is needed. The use of supply side measures will need to become more prevalent as the ability of the European Central Bank to take the strain alone is depleted. The economic stimulus baton needs to be passed on. Economic reform often requires governments to make difficult and sometimes unpopular shorter-term decisions in anticipation of more medium-term benefits. However, this process should get a boost later this month through the likely re-election of Angela Merkel as German Chancellor. At this stage in her political career – after more than a decade as the German leader – Merkel will be looking towards her legacy. A close economic-reform-inducing partnership with President Macron, applied across the Continent in the manner of those applied to the German economy with great success in the 1990s, would be a material achievement.

As always at times of great challenge – and opportunity – great leaders often emerge. European investors must hope that the combination of German encouragement, a large parliamentary majority for the French Presidency and an awareness of the need for change will lead to change. Unless there is progress by the end of this year, 2018 may not be a happy year for European investments. The time for talking has stopped. The time to deliver economic reforms has arrived. If achieved, a stronger, more cohesive and faster growing Europe will result – and that is likely to be to the benefit of all.

Chris Bailey is European Strategist at Raymond James