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Market Commentary

Downgraded: France Gets a Wake-Up Call
November 21, 2012  Bill Witherell, Chief Global Economist and Portfolio Manager

Moody’s cut France’s rating one notch to Aa1 and is maintaining a negative outlook for France. This is not surprising, as it follows a similar move by S&P last January, but it caps what has been a very difficult month for France and its leaders. Our October 1 commentary, “French Impressions,” laid out the problems, concluding that if France is “… to avoid what could be a steep increase in its cost of funding the large deficits, it needs to undertake a number of market-oriented economic reforms.”  This refrain has been repeated and amplified in recent weeks from many quarters. Last Friday’s issue of The Economist included a 14-page Special Report on France entitled “The time-bomb at the heart of Europe” and a cover featuring a bomb made of French baguettes.  We discuss below why the spotlight is now on France.

On November 5th, in its annual report on France, the International Monetary Fund (IMF) warned that the outlook for France is “clouded by a significant loss of competitiveness relative to its trading partners. This competiveness gap is reflected not only in deteriorating export performance, but also in the low profit margins of enterprises, which constrain their capacity to invest, innovate and create jobs.”  This problem could become  “… even more severe if the French economy does not adapt along with its major trading partners in Europe, notably Italy and Spain, which following Germany, are now engaged in deep reforms of their labor markets and service sectors.” The IMF urged France to carry out “a comprehensive program of structural reforms,” including fiscal deficit reductions and an improvement in the quality of fiscal adjustment in order to strengthen incentives to work and invest; to correct labor-market impediments to investment, employment, and ultimately growth; and to increase competition in the services sector.

The problems the IMF flagged were reflected in the Global Economic Forum’s low ranking of France at the 21st position in their latest Global Competitiveness Report, well under the ranking of their most important trading partner, Germany, which is ranked 6th, behind only Switzerland, Singapore, Finland, Sweden, and the Netherlands.  France remains considerably above Spain’s 36th and Italy’s 42nd positions, but these rankings do not yet reflect the substantial reforms in those two countries.  France, in fact, has slipped in its current ranking from position 18 in the previous survey.

Drilling down into the subcategories and components of the Competitiveness Report, notable problem areas for France include its macroeconomic environment (68th), labor-market efficiency (66th), goods-market efficiency (46th), institutions (32nd), and higher education (27th).  Relative strengths are infrastructure (4th), market size (8th), and technological readiness (14th).

The World Bank has recently published Doing Business 2013, the latest volume in an annual review of regulations that enhance or constrain business activity, covering 183 economies.  Here too France’s ranking slipped, from 29th in 2011 to 34th in 2012. The worst subcategories for France were registering property (146th), protecting investors (82nd), getting credit (53rd), paying taxes (53rd), dealing with construction permits (52nd), and resolving insolvency (43rd).

Reducing the regulatory impediments to doing business in France will be a formidable task, in view of the nation’s long love affair with regulation.  The above-cited issue of The Economist cites one example of this excessive regulation: France has a remarkable number of firms with 49 employees. This is surely due to the fact that many regulations become effective when a firm has 50 or more employees.

On the same day France received the warning from the IMF, Louis Gallois, former head of the aerospace group EADS, released a report on France’s competitiveness, commissioned by the French government.  Gallois recommended a 30-billion-euro “competitiveness shock” in the form of a cut in the heavy social-welfare charges on employers and employees.  This followed an open letter from the chief executives of companies listed on the CAC 40 stock exchange, calling on President Hollande to slash public spending by 60 billion euros – 3% of GDP – over 5 years.

The Hollande government responded with some positive moves but indicated they would prefer to use the term “competitiveness trajectory” or “pact,” rather than “shock.” The positive steps include a 20-billion-euro tax break for business and some 34 other measures, which together are projected by the government to lead to the creation of 300,000 jobs and add half a percentage point to annual economic growth over the next five years.  Prime Minister Jean-Marc Ayrault said the tax credits amount to a 6% cut in France’s labor costs, now among the highest in Europe.  These are moves in the right direction, but substantially more is needed, and time is running out.

France’s finance minister, Pierre Moscovici, rejected the idea that France could become the next focus of the eurozone crisis. He stressed that France remains the world’s fifth largest economy. It is also the sixth-biggest exporter, and in the first half of this year it was the world’s fourth-biggest recipient of foreign investment. It is at the core of the eurozone both economically and politically. These facts underline how important France is, not only to Europe but also to the global economy and markets. While the “time-bomb” cover picture featured by The Economist might well be considered an overly dramatic view of the present situation, the title of one section of their report, “So much to do, so little time,” sums up our concerns. The bond market is not known for its patience. Market sentiment could rapidly turn against France.

So far markets have been kind to the Socialist government in France, despite the S&P downgrade last January and the anti-business actions of the new government soon after coming to power. The French bond market has rallied over 9% since the S&P downgrade, more than double the gains of the rest of the global bond market, according to the Bank of America Merrill Lynch indexes. French credit default swaps remain below 100 basis points. They were well over 200 basis points last summer. Tuesday’s yield increase following the Moody’s downgrade was only 8 basis points, not that different from the 7-basis-point increase for the U.K. and 6-basis-point increase for Germany. Relative to the Italian bond market, the 1.3 trillion French bond market continues to attract safety-conscious investors and it does provide a positive, if small, return compared to Germany’s negative short-term yields.

The French equity market, as measured by the CAC 40, actually ended up +0.65% yesterday and is up over 8% year-to-date.  That is less than the 15.8% year-to-date increase in the MSCI equity index for Germany but about the same as the +8.3% year-to-date for the MSCI equity index for the world.

France clearly has the means to avoid becoming the “sick man of Europe.”  Sweden, Germany, and now Spain and Italy have shown what needs to be done. While the Hollande government shows signs of finally recognizing the problem and while its party is very well-situated to act, controlling the legislature and most regional governments, it still appears to be hesitant to act with the boldness and the speed that is required. Hollande and Ayrault have yet to demonstrate that they have the leadership qualities needed to face down the protests in the streets that such changes will surely generate.  We wish the best for France but are still refraining from including France in our International and Global Multi-Asset Class portfolios. Indeed, we have recently reduced our positions for Germany, our only eurozone position.

Bill Witherell, Chief Global Economist and Portfolio Manager

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