Will the euro have its day?

By Arthur Kamp, economist at Sanlam Investments

The Netherlands general election, held on 15 March 2017, was not expected to rattle markets. And it hasn’t.

It was assumed that even if the Party for Freedom (PVV), which opposes immigration and the euro,  won the election it would not garner sufficient votes to govern as the remaining mainstream parties, which are unlikely to affiliate themselves with the PVV, would effectively rule through a coalition. In the event, although the final tally is not available at the time of writing, it appears as though the PVV has lost ground and that the mainstream People’s Party for Freedom and Democracy (VVD) is likely to gather the most votes. Indeed, the euro has strengthened against the US dollar in the immediate aftermath of the polls.

Attention will now turn to the French presidential election, the first round of which will be held in late April 2017. Marine Le Pen, a euro-sceptic from the National Front, may yet win this round, but polls suggest that ultimately, in early May 2017 Emmanuel Macron (an independent reformist) is likely to win the second round (which is likely to be needed since no clear majority is expected to emerge in the first round for any of the candidates).

A Le Pen win in the second round is deemed a low probability event, but should it occur it could have a high impact since she may well seek to call a referendum on euro membership. It is unclear whether Le Pen would seek to do this before or after the legislative election in June 2017, although should the National Front perform well during the June election it would ostensibly strengthen her position. Even then it is not clear whether she would be able to muster sufficient support in parliament to enable her to call an election on France’s euro membership. At the very least, though, a Le Pen win would prolong uncertainty.

Further, from a long-term perspective there is risk in Europe, since the implementation of economic reforms needed to lift income growth is likely to be slow in countries such as Italy and France where the political environment may not be conducive to decisive policy action. Even modest labour market reforms implemented in France last year resulted in push-back on the political front. This continues to hold material long-term risk to debt dynamics in these countries – especially in the absence of a decisive shift towards a fiscal union in Europe. One may not favour the euro until this uncertainty is cleared.

That said, although we cannot predict the future, it is worth asking whether there is a case for the euro after all, even as the US Federal Reserve continues to hike its policy rate.

We observe that the gap in the annual advance in real GDP growth between the Euro area and the US has narrowed, while the former also runs a material current account surplus. Further, since deflation concerns are receding the European Central Bank (ECB) may well signal a shift towards a less accommodative monetary policy stance at some point. Moreover, the euro is trading at a level materially weaker than our purchasing power estimate suggests it should.

And, finally, when all is said and done, leaving the euro is likely to be highly disruptive to economies. Many Euro area governments are relying on the ECB balance sheet to anchor government borrowing rates at low levels. In any breakaway scenario one would mostly expect the currencies of secession countries to devalue, while their real interest rates could increase materially, leaving government finances exposed. A potentially high cost to disintegration, therefore, remains a significant deterrent.

Who knows, the euro may well have its day again.