- Macron's vision for a unified EU has led to euro strength since his victory
- The first dent in this vision followed German elections, today's development is more serious
- Thanks to an ongoing bull market, the euro's sell-off has been mild so far
Following Macron’s significant victory in the French elections earlier in May, fears of the euro’s demise took a backseat to renewed optimism. Preceding the election, many predicted that a Eurosceptic political party would rise in France, putting the entire region at risk. Instead, Macron won the election, seemingly based on his ‘Europhile’ credentials.
Later in September, he delivered a landmark speech and advocated for a big increase in the European Union’s scope of activities. In particular, he called for a joint defense force, a dedicated finance ministry, common corporate taxes, and a streamlined European Commission. In short, he called for a significant increase in the pace of centralization of political power within the EU. More importantly, he called for a new Franco-German axis to lead the future. Given Germany’s economic significance, Macron ultimately has limited leeway in enacting reforms to the EU unilaterally.
German electorate have other ideas
Unfortunately for Macron, the timing of his speech was far from optimal. Two days earlier, Angela Merkel’s CDU/CSU suffered its worst result since 1949. A series of political mistakes such as the party’s liberal refugee policy, clean energy initiatives (which have resulted in sharply higher energy costs for households), and calls for more integration with the rest of the EU fell flat with voters. While the main opposition party (the Social Democrats) fared even worse, non-mainstream parties such as the Free Democrats and the AfD (Alternative for Germany) were able to capitalize on Merkel’s weakness.
Following today’s collapse in coalition discussions, Germany looks set to return to elections as Merkel has refused to form a minority government. From Merkel’s perspective, the high stakes gamble makes sense. As the EU is in dire need of reform, the region needs German leadership. Without a clear mandate in the form of a majority in the Bundestag, Merkel risks becoming a lame duck.
A bull market hides the EU’s bigger problems
In an earlier commentary, we wrote that euro trading will be driven by politics and economics as the ECB is temporarily out of the picture. While forward-looking economic indicators and recent GDP growth figures have supported the euro, the picture is murkier in the longer term for three big reasons.
Firstly, the ECB’s extraordinary monetary policies are unlikely to stay in place beyond 2018. At some point, the Governing Council will bow to pressures from hawkish members and end its asset buying program in order to remain credible. Secondly, Merkel’s failure to form a government increases the risk of Germany turning inwards. Economic conditions today are ideal for instituting tough reforms across the EU, and this opportunity may be squandered without German leadership. Lastly, Eurozone GDP growth has mathematical limits and is more likely to decelerate in the coming future. Given the problem of base effects (mathematically, delivering growth on top of good historical growth is more challenging), Eurozone growth runs the risk of decelerating in 2018. A historical overview of recent GDP growth is shown below for reference:
Where’s the cycle? Remarkable EZ growth may be approaching limits
All in all, today’s price action in the euro makes sense given this context. Thanks to an ongoing bull market, the sell-off in the euro has been fairly mild so far despite the significance of today's events. That being said, if Germany fails to take leadership of the Eurozone, this will have serious consequences for the common currency over the long-term. Without successful institutional reforms, expect the next down cycle to develop into a full-blown crisis.