A Tale of Two Countries

Author: Bill Witherell, Ph.D., Post Date: September 26, 2017
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Currently visiting France, a country in which I lived for some 26 years, I am struck by the widespread optimism about the economic and political future of the nation. This upbeat sentiment contrasts sharply with French attitudes in recent decades and with the situation across the Channel in the United Kingdom as that country struggles to deal with the emerging implications of its fateful decision to withdraw from the European Union (Brexit).

French optimism appears to be based on the strength of the economic recovery that is underway, together with the election of a new reform-minded president, Emmanuel Macron, whose centrist government has a substantial majority that can support reform initiatives. France’s economy, the second largest in the Eurozone after Germany’s, is participating in a healthy economic expansion in the Eurozone.

France’s most recent leading indicators suggest some softening in the third quarter, perhaps due to uncertainty about the impact of the new government’s proposed reforms. Nevertheless, the outlook remains robust, with another strong round of job creation. Household spending has strengthened. Even more important, exports have rebounded with the upswing in global trade more than offsetting the effect of a strengthening currency. The annual GDP growth rate for this year looks likely to be 1.7%, up significantly from last year’s 1.1%. An even faster pace, 1.9%, is projected for next year as the recovery becomes more widespread and balanced.

The French people have elected by a wide margin a young, charismatic president whom the majority believe has a strong chance of strengthening both France and Europe. Macron’s election, followed by the success of his supporters in the subsequent parliamentary election, is seen as effectively ending the rise of populism in Europe. While Macron will likely find it difficult to obtain agreement on all of his ideas for reforming the European Union (EU), his efforts to convince Germany’s Chancellor Angela Merkel, who was re-elected on Sunday, September 24, to join his reform initiatives should bring about some positive results.

The strength of Macron’s parliamentary support implies that his domestic reforms have a good chance of being enacted. France is experiencing a period of work stoppages, demonstrations, and other annoyances fomented by some, but notably not by all, labor unions. While the hard-line communist CGT has been leading the protests, the largest trade union syndicate, CFDT, and Force Ouvriere have declined to participate. The number that turned out on a “Day of Strikes” fell well below the huge numbers that last year protested less ambitious labor market reforms. The general view appears to be that most of the domestic reform initiatives will proceed without significant alterations.

Indeed, on Friday Macron formally signed five decrees reforming France’s labor rules. These reforms will give firms more flexibility to negotiate working conditions. Employers will be able to reach deals directly with their employees. Small firms will be allowed to bypass union agreements and will be freed of many constraints. Redundancy rules will be less punitive. Government programs to subsidize jobs will shrink. These changes will add up to substantial labor market reform, changes that seemed impossible for past governments.

In the United Kingdom it is difficult to find evidence of the kind of optimism apparent in France. The economic picture is mixed. Uncertainty about Britain’s future relationship with the EU has not yet had the anticipated effect of curbing either domestic or inward foreign investment, yet polls of business attitudes suggest little support for the government’s Brexit strategy. Clearly, should the reality of Brexit in 18 months bring restricted immigration of needed workers and/or failure to reach an acceptable trade deal, business investment will be hurt. Purchasing Managers’ Index surveys for August showed that solid progress in new orders, output, and employment in the manufacturing sector were more than offset by slowdowns in services and construction. Overall economic expansion was the weakest in six months.

We anticipate that Brexit-related uncertainty will lead to slower growth in 2018, perhaps 1.5%, compared with this year’s projected 1.7% pace. Adverse developments in the negotiations could slow growth further, while clear progress towards a “soft Brexit” with substantial continued access to the single market would improve economic prospects.

Currently it is the political situation in Britain that is darkening the public’s mood. Prime Minister Theresa May’s weak government depends on support from several members of a small right-wing Northern Ireland party to maintain a majority. Within her Conservative Party and within her cabinet there is a sharp division on the government’s strategy for the Brexit negotiations with the EU.

Prime Minister May’s views have evolved. She formerly promised a “hard Brexit” with little scope for compromise with the EU, but her stance has become more moderate. She now is calling for a two-year transition period after March 2019, during which EU market access would continue. She promised to pay “a fair share” of the EU budget and added that the UK does not want to stand in the way of closer EU integration. At the same time, May has moved to take greater control of the negotiations, following an effort by her outspoken foreign minister, Boris Johnson, to push her in the opposite direction. The outcome for Britain remains highly uncertain.

Central bank policy outlooks also differ for France and the UK. President Draghi of the European Central Bank (ECB) has indicated that they are upbeat on the European economy but dissatisfied with the subdued pace of inflation. The strengthening of the euro is also likely a concern. Therefore, while some reduction in the ECB’s monetary stimulus through bond purchases is likely to begin soon, the process of “tapering” is expected to be gradual. No interest rate increases appear likely for some time, perhaps not until late 2019.

The Bank of England (BOE) sees the current healthy pace of growth reducing spare capacity and, in contrast to the situation in the Eurozone, sees inflationary pressures rising. It now looks likely that the BOE will raise interest rates as early as its November meeting. Together with the government’s restrictive fiscal policy, consumers hit by rising prices and low wage growth, and Brexit uncertainty, higher interest rates would add to our concerns about the UK’s economy next year.

We are not alone with such concerns. On Friday Moody’s downgraded the U.K. To an Aa2 rating from Aa1.  Moody’s gave as reasons their fears that Brexit could damage the country’s economic growth and concerns about the U.K.’s debt reduction plans.

Equity markets are reflecting the difference in the outlooks for the French and UK economies. The iShares MSCI France ETF, EWQ, has a September 21 year-to-date total return of 26.9%, while the iShares MSCI United Kingdom ETF, EWU, has gained 14.64%.

Bill Witherell, Ph.D.
Chief Global Economist
Email | Bio

Sources: Financial Times, Goldman Sachs Economic Research, Oxford Economics, The Economist, iShares.com


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