French politics, UK macro data and possible GBP/EUR downside

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Reminder: I will be discussing the upcoming first round of the French Presidential Elections in a Q&A session hosted by Speevr Live today at 14.30 London time. Click here to watch live or replay

French politics and UK macro data point to possible GBP/EUR downside

The GBP/EUR cross is at year-highs but continues to struggle to breach the 1.20 mark, as it did on a number of occasions in the second half of 2016. Sterling has been buoyed by British Prime Minister Theresa May’s call for early general elections on 8th June while the euro remains in reasonably narrow trading ranges as we head into Sunday’s French presidential election first round.

With four presidential candidates polling between 18.5% and 23.5%, it is still a close call (see Figure 1). But I am sticking to my core scenario that independent centre-left candidate Emmanuel Macron will fill one of the top two spots to make it to the 7th May run-off, which in my view would be welcomed by French financial markets and the euro even if markets remain jittery over the next fortnight (see The Ultimate Guide to the 2017 French Elections, Part IV, 13 April 2017).

At the same time, the ever-changing political scene in the UK can do little near-term to avert the headwinds to GDP growth stemming from falling real wages and retail sales. With this in mind, I see the risk to GBP/EUR biased to the downside in coming weeks, particularly if both Macron and Republican candidate François Fillon earn their place in the second round.

 

French election first round a close call but Macron still most likely president

French voters will vote on Sunday in the first of likely two rounds for the French presidential elections. The close race between the top four candidates, which is unprecedented in French election history, implies that there are six possible run-off scenarios for the second round on7th May. French Financial markets and the euro have so far dealt calmly with this uncertainty. Implied euro volatility has jumped as financial markets hedge their bets but actual euro volatility has remained subdued, French government bond yields have treaded water and French equities are still within touching distance of their all-time high.

 

 

If, as per my core scenario, Macron makes it to the second round, I would expect French financial markets and the euro to appreciate in due course. Given lingering doubts about the robustness of opinion polls, markets would likely remain jittery should Macron face National Front leader Marine Le Pen and in particular far-left candidate Jean-Luc Mélenchon in the second round. However, French opinion polls have historically accurately predicted the outcome of second round votes (see The Ultimate Guide to the 2017 French Elections, Part III, 5 April 2017) and polls show that Macron would beat Le Pen by a large margin (about 63% vs 47%) and Mélenchon by a reasonably comfortable margin (54% vs 46%).

Should Macron and François Fillon both make it to the second round, I would anticipate French financial markets and the euro to rally with intent as both candidates have campaigned on the back of broadly market-friendly policies, including looser labour laws and fiscally-neutral or positive pledges.

 

UK macro data highlight economic realities beyond political best-case-scenarios

On the other side of the Channel, British voters will once again return to the voting booths following Prime Minister Theresa May’s decision to call early general elections on 8th June – the third major popular vote in two years. Opinion polls suggest that the ruling Conservative Party, which currently has 330 seats in the 650-seat House of Commons (lower house of parliament) could win up to 400 seats in a landslide victory. This would significantly increase its parliamentary working majority from 17 seats at present, with Jeremy Corbyn’s beleaguered opposition Labour Party the biggest loser.

From a domestic perspective, Theresa May’s motivations are pretty clear – to win an overwhelming popular mandate (she was elected back in July in a party leadership battle, not a general election) in order to carry through her own policy program rather than the one she inherited from her predecessor David Cameron. In the context of Brexit negotiations, a landslide victory on 8th June would largely free her from the dissent of eurosceptic Conservative parliamentarians and of those still pushing for the UK to remain in the EU, including members of the Labour Party, Liberal Democrats and Scottish National Party. Also, by pushing back the next general elections by two years to mid-2022, she has bought herself more time to negotiate a deal with the EU after the UK ceases to be a member in March 2019.

Financial markets seem to have concluded that Theresa May will enjoy greater negotiating powers and that soft-Brexit – including a transitional agreement – was now more likely than the UK simply exiting without a deal in place and reverting back to WTO trading rules. Sterling, in trade weighted terms, jumped to its highest level since early December, according to my estimates, following Theresa May’s announcement on 18 April (see Figure 2) and the IMF’s release of once-again upwardly revised GDP growth forecasts for the UK.

Whether this greater political freedom for Theresa May translates into a softer or harder form of Brexit remains, in my view, open to debate. As unsatisfying as it may be, only time will tell and negotiations with EU leaders about the terms and conditions of the UK’s new deal are unlikely to properly start until next year. But what Theresa May can do little about near-term are the realities facing the British economy (and arguably the government’s attention over the next seven weeks will be focussed on campaigning).

 

olivier desbarres april review fig 2 and 3

 

Declining UK real wages and retail sales and likely slower GDP growth

One of these realities is that contracting real wages alongside slowing unsecured consumer borrowing has lead retail sales to shrink which is in turn likely weighing on UK GPD growth – a risk which I first identified in August (see UK economy post referendum – for richer,  but mostly for poorer, 26 August 2016). The mechanics are summarised in Figure 4.

 

olivier desbarres april review fig 4

 

At the heart of the problem is the fact that workers’ nominal earnings are simply failing to keep up with rising inflation (see Figure 3). One explanation is that despite the fall in the pool of available labour, workers’ power to negotiate higher nominal earnings remains weak (see Figure 5). The result is that real weekly earnings have now fallen in 9 of the past 13 months and were down 1.3% between November 2016 and February 2017 (see Figure 6).

 

 

At the same time, growth in non-secured bank lending – which had arguably helped prop up consumer demand – has been slowing, partly in due to a moderation in demand and tighter lending standards (see Figure 7). Moreover, the Bank of England’s latest survey shows that banks expect to further tighten lending standards in Q2 (see Figure 8).

 

 

The combination of weaker lending growth and falling real wages has weighed on retail sales, with the volume of retail sales contracting 1.5% in Q1 2017 (see Figure 9). This is the first quarterly contraction since Q4 2013 and the largest contraction since Q1 2010 – broadly in line with my forecasts (see Bank of England – Sense of déjà-vu, 24 March 2017). Figure 9 also shows a reasonably high correlation between UK retail sales and consumption growth, despite household consumption also including services and purchases from abroad while excluding tourists’ estimated expenditures.

A contraction in retail sales would therefore point to soft household consumption growth in Q1 2017, which would in turn have likely weighed on GDP growth (see Figure 10). Indeed, while the Office of National Statistics will only release preliminary Q1 GDP data on 28 April and more detailed second estimates on 25 May, it has already warned that weak retail sales likely shaved 0.1 percentage points off quarter-on-quarter GDP growth in Q1. Headwinds to growth may well reignite the debate about the British economy’s resilience in the wake of the 23 June EU referendum and in turn weigh on Sterling, particularly when the complexity of the negotiations on a new EU deal (which the British government will likely start later this year) starts coming into focus.

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

 

PRIOR RESEARCH ON FRENCH ELECTIONS AND EUROPEAN NATIONALISM

The Ultimate Guide to the 2017 French Elections, Part IV, 13 April 2017

The Ultimate Guide to the 2017 French Elections, Part III, 5 April 2017

The Ultimate Guide to the 2017 French Elections, Part II, 29 March 2017

Going Dutch and Fed’s next big data hurdle (17 March 2017)

Fed 25 and 500 Godfathers (10 March 2017)

The Ultimate Guide to the 2017 French Elections – Part I (7 March 2017)

French elections in focus but US data likely to draw attention (24 February 2017)

Black Swans and white doves (8 December 2016)

EM currencies, Fed, French elections and UK reflation-lite (25 November 2016)

Nationalism, French presidential elections and the euro (18 November 2016)

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