Europe

Special Report

Feature Feature ChartThe Sales Of Makeup And Perfumes Collapsed, But The Sales Of Hair Care And Skin Care Grew The pandemic era is diminishing our close quarters intimacy with people, which raises a fascinating question. In a world of social and physical distancing, widespread use of face coverings, and virtual meetings on Zoom or Skype, is it still important to look good? Is it important to smell good? And perhaps the most fascinating question of all: is it important to feel good? The so-called ‘lipstick effect’ is a putative counter-cyclical phenomenon during recessions in which the demand for small treats and pick-me-ups increases while other spending is shrinking. One theory is that it is based on the basic human desire to feel good, even during hard times. When budgets are squeezed, people simply cut out large extravagances and substitute them with small luxuries, epitomised by lipstick. The lipstick effect was first recorded during the Great Depression. Between 1930 and 1933, unemployment in Germany surged to six million. But thanks to the booming demand for its cosmetics, the German firm Beiersdorf could boast that it did not have to lay off a single worker. Across the Atlantic, the same was true. When US economic output shrank by a third, cosmetics were one of the few products whose sales grew. The lipstick effect was also observed during the Great Recession. Between September 2008 and January 2009 when US consumer spending shrank, the sales of cosmetics bucked the downtrend, and grew (Chart I-2).  Chart I-2Cosmetics Sales Grew In The 2008 Recession... The Lipstick Effect Is Working In An Evolved Form Fast forward to 2020, and the pandemic-induced economic slump is the one recession in which we would expect not to observe the lipstick effect. After all, if you are in lockdown, or must maintain physical distancing with other people, or must wear a face covering when near other people, what is the point of wearing makeup or perfume? The sales of cosmetics and fragrances collapsed in the 2020 recession… Just as we would expect, between February and April this year, the US sales of cosmetics and fragrances collapsed by 18 percent, exactly in line with the plunge in US consumer spending. On the face of it, the lipstick effect does not work under a facemask (Chart I-3). Chart I-3...But Shrank In The 2020 Recession Yet on closer examination, the lipstick effect is working, albeit in an evolved form. While the sales of makeup and perfumes have collapsed in 2020, the sales of skincare and haircare products are growing (Chart I-1). As the pandemic took hold and forced hair and beauty salons to shutter, people replaced salon visits with at-home care routines. And interestingly, even in the Great Recession of 2008-09, the US sales of haircare and non-cosmetic personal products outperformed the sales of cosmetics (Chart I-4-Chart I-7). Chart I-4Hair Care And Skin Care Sales Grew In The 2008 Recession... Chart I-5...And Grew In The 2020 ##br##Recession Chart I-6Total Personal Products Sales Grew In The 2008 Recession... Chart I-7...And Have Held Up Well In The 2020 Recession In fact, 60 percent of the total beauty market comprises skincare and haircare products compared with 30 percent for makeup and perfumes (Chart I-8). It turns out that the cosmetics and personal products firms that have a diversified exposure to all segments of the beauty market are the ones that outperform in hard times as well as good. And it turns out that these companies are European. Chart I-8Skin Care And Hair Care Dominates The Beauty Market The European Cosmetics Sector Is Outperforming In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed the US cosmetics sector, led by Estee Lauder, and the Japanese cosmetics sector, led by Shiseido. In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed. Specifically, the 12-month forward earnings for the European cosmetics sector barely declined in the 2008-09 recession and have barely declined in the 2020 recession. In contrast, the forward earnings for the US and Japanese cosmetics sectors collapsed both then and now (Chart I-9). Chart I-9The European Cosmetics Sector Has Been Recession-Proof Furthermore, the latest quarterly reports show that while operating profits for L’Oréal are down by around 20 percent from a year ago, the operating profits for Estee Lauder and Shiseido have slumped by more than 80 percent.1 As a result, the L’Oréal share price took a much smaller hit than those of Estee Lauder and Shiseido in both the 2008 and the 2020 stock market crashes (Chart I-10 and Chart I-11). Chart I-10L’Oréal Took A Smaller Hit Than Estee Lauder And Shiseido In 2008… Chart I-11…And In ##br##2020 An important reason for L’Oréal’s consistent outperformance is its diversified product range. L’Oréal acknowledges that for both its consumer products and luxury divisions “the health crisis triggered a sharp deceleration in the makeup market”. But the hit to makeup was counterbalanced by continued strong growth in skin care thanks, for example, to the launch of serums in its Revitalift range. Additionally, its hair care products grew thanks to Fructis Hair Food plus very strong performance in the “highly dynamic home-use hair colour market”.  Estee Lauder confirms that “Covid-19 and its various impacts have influenced consumer preferences due to the closures of offices, retail stores and other businesses and the significant decline in social gatherings”. While the demand for makeup and fragrance has slumped, the demand for skin care and hair care products has been more resilient. The trouble is that hair care accounts for less than 4 percent of Estee Lauder’s total sales. Meanwhile, the collapse in makeup sales has forced goodwill asset impairments to several of its makeup brands causing the 80 percent collapse in its overall profits. Likewise, Shiseido blames the 83 percent slump in its operating profits largely on “a product mix deterioration” which outweighed prompt cost-saving measures in response to the rapid deterioration of the market environment. Another vulnerability is that Shiseido’s sales are highly concentrated in Asia. By comparison, L’Oréal benefits from geographical diversification, with sales almost equally split between Europe, the Americas, and Asia (Table I-1). Table I-1L’Oréal Benefits From Geographical Diversification The European Personal Products Sector Is Also Outperforming Turning to the general personal products sector, the leading companies are Unilever and Beiersdorf in Europe, Procter & Gamble, Colgate-Palmolive, and Kimberly Clark in the US, and Kao in Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. Indeed, while the European sector’s profits have steadily grown through the past decade, the US sector’s profits have been going nowhere since the mid-2010s (Chart 1-12). Chart I-12The European Personal Products Sector’s Profits Have Grown Through The Past Decade   One reason for the European personal products sector’s reliable growth is that both Unilever and Beiersdorf are highly exposed to the beauty sector – in fact, Unilever has an even larger market share than Estee Lauder (Chart I-13). And as we have just seen, a diversified exposure to all segments of the beauty sector – makeup, fragrances, skin care, and hair care – should produce resilient growth in all economic backdrops. Pre-pandemic, and potentially once the pandemic is over, makeup and fragrances were/will be the growth drivers. Whereas during the pandemic, skin care and hair care are the drivers. Chart I-13Unilever Is A Big Player In Beauty A final point is that despite the superior and safer growth prospects of the European cosmetics and personal products companies, they are not generally more richly valued than their peers in the US and Japan (Table I-2 and Table I-3). Table I-2The European Cosmetics Sector Is Not More Expensive Table I-3The European Personal Products Sector Is Not More Expensive To sum up, for the pandemic era and beyond, the European cosmetics and personal products sector is well set for diversified growth via product mix, price points, and regional exposures. And it is relatively well valued versus its peers elsewhere in the world. As such, the sector – dominated by L’Oréal, Unilever, and Beiersdorf – should remain a core holding in an investment portfolio.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Mohamed El Shennawy Research Associate mohamede@bcaresearch.com Footnotes 1 The most recent quarterly report for Estee Lauder is due on August 20. But at the time of writing the latest quarterly report was to the end of June 2020 for L’Oréal and to the end of March 2020 for Estee Lauder and Shiseido.

Highlights Global Credit Spreads: The relentless rally in global credit markets since the rout in February and March has driven corporate spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the coronavirus and US politics. Credit Strategy: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both. Feature Chart of the WeekA Pandemic? Credit Markets Are Not Concerned Global credit markets have enjoyed a spectacular recovery from the carnage seen just five months ago when investors realized the magnitude of the COVID-19 shock. The option-adjusted spread (OAS) on the Bloomberg Barclays Global Investment Grade Corporate index has tightened from the 2020 high of 326bps to 130bps, while the OAS on the Global High-Yield index has narrowed from the 2020 high of 1192bps to 556bps. Unsurprisingly, those spread peaks both occurred on the same day: March 23, the day the US Federal Reserve announced their corporate bond buying programs. We have described the Fed’s actions as effectively removing the “left tail risk” of investing in credit, and not just in the US, by introducing a central bank liquidity backstop to the US corporate bond market. The backdrop for global credit markets, on the surface, seems typical for sustained spread compression (Chart of the Week). Economic optimism is buoyant, with the global ZEW expectations index now at the highest level since 2014. Monetary conditions are highly supportive, with near-0% policy rates across all developed economies and the balance sheets of the Fed, ECB, Bank of Japan and Bank of England growing at a combined year-over-year pace of 46%. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US.  The next moves in credit will be more challenging and less rewarding than the past five months. Investment grade corporate credit spreads no longer offer compelling value in most developed economies, while high-yield spreads are tightening in the face of rising default rates in the US and Europe. While additional spread tightening is not out of the question in these markets, investors should consider rotating into credit sectors that still offer some relative value – like emerging market (EM) hard currency corporates. A World Tour Of Our Spread Valuation Indicators The sharp fall in global bond yields over the past several months has not just been confined to government debt. Yields have fallen toward, and even below, pre-virus lows for a variety of sectors ranging from US mortgage-backed securities (MBS) to EM USD-denominated sovereign debt (Chart 2). Investors are clearly reaching for yield in the current environment of tiny risk-free government bond yields, with no greater sign of this than the recent new issue by a US sub-investment grade borrower of a 10-year bond with a coupon below 3%.1 The drop in credit yields has also occurred alongside tightening credit risk premiums, although spreads remain above the pre-virus lows for most sectors in the US, Europe and EM (Chart 3). The degree of correlation across global credit markets has been intense, with very little differentiation between countries. Investment grade corporate spreads in the US, UK and euro area are all closing in on 100bps; high-yield spreads in those same regions are all around 500bps. Chart 2Global Credit Yields Are Low Chart 3Global Credit Spreads Are Getting Tight Last week, we introduced the concept of “yield chasing” to describe how the ranking of returns in developed market government bonds was becoming increasingly correlated to the ranking of outright yield levels.2 We have seen a similar dynamic unfold in global credit markets, especially since that peak in spreads in late March. In Chart 4 and Chart 5, we present the relationship between starting benchmark index yields, and the subsequent excess returns over risk-free government bonds, for a variety of developed market and EM credit products. The first chart covers the time from start of 2020 to the March 23 peak in spreads, while the second chart shows the relationship since then. The two charts are mirror images of each other. Chart 4Starting Yields & Subsequent Global Credit Excess Returns In 2020 (January 1 To March 20) Chart 5Starting Yields & Subsequent Global Credit Excess Returns In 2020 (Since March 23) The worst performing markets in the first three months of the year were those with the highest yield to begin 2020: high-yield corporates in the US and Europe along with EM credit, which have been the best performing markets since late March. The opposite is true for lower yielders like investment grade credit in Japan, the euro area and Australia, which were among the top performers before March 23 and have lagged sharply since then. While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Chart 6Lower Vol = Lower Credit Risk Premia While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Measures of bond volatility like the MOVE index of US Treasury options prices have declined to pre-pandemic lows, while the VIX index of US equity volatility is now down to 22 from the 2020 peak around 80 (Chart 6). The excess return volatility of US corporate bond markets has followed suit, thus allowing for lower US credit spreads. Even allowing for the lower levels of overall market volatility, corporate credit spreads do look relatively tight in the US and Europe. The ratio of the US investment grade index OAS to the VIX is now one standard deviation below the median since 2000 (Chart 7). A similar reading exists for the ratio of the US high-yield index OAS to the VIX, which is also one standard deviation below the long-run average (bottom panel). In the euro area, the ratios of investment grade and high-yield OAS to European equity volatility, the VStoxx index, are not as stretched as in the US, but remain below long-run median levels (Chart 8). Chart 7Very Tight US Corporate Credit Spreads Relative To Equity Vol Chart 8Tight Euro Area Corporate Credit Spreads Relative To Equity Vol While these simple comparisons of spread to market volatility suggest that corporate credit spreads are tight in most major markets, other indicators paint a more nuanced picture of cross-market valuations. Our preferred measure of the attractiveness of credit spreads is the 12-month breakeven spread. That measures the amount of spread widening that must occur over a one-year horizon for a credit product to have the same return as government bonds. In other words, how much must spreads increase to eliminate the carry advantage of a credit product over a risk-free bond, after accounting for the volatility of that product. We compare those 12-month breakeven spreads with their own history in a percentile ranking, which determines the attractiveness of spreads. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. A look at breakeven spread percentile rankings for the major credit groupings in the US (Chart 9), euro area (Chart 10) and EM (Chart 11) shows more diverging spread valuations. Chart 9US Corporate Bond Breakeven Spread Percentile Rankings Chart 10Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 11EM USD Credit Breakeven Spread Percentile Rankings The US investment grade breakeven spread is just below the 25th percentile of their long-run history, although the high-yield breakeven spread remains in the top quartile of its history. Euro area breakeven spreads are “fairly” valued, both sitting around the 50th percentile. The EM USD-denominated sovereign breakeven spread is in the third quartile below the 50th percentile, while the EM USD-denominated corporate breakeven spread looks better, sitting just at the 75th percentile. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. We would not be surprised to see US investment grade spreads tighten back to the previous cyclical low at some point in the next 6-12 months. There are more compelling opportunities in other global credit markets, however, especially on a risk-adjusted basis. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. Bottom Line: The relentless rally in global credit markets since the out in February and March has driven credit spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the virus and US politics. Spread valuations are looking more stretched, but “yield chasing” and “spread chasing” behavior will remain dominant with central banks encouraging risk-seeking behavior with easy money policies. Putting It All Together: Recommended Allocations One way to look at the relative attractiveness of global spread product sectors is to compare them all by 12-month breakeven spread percentile rankings. We show that in Chart 12, not just for the overall credit indices by country but also among credit tiers within each country. Sectors rated below investment grade are in red to differentiate from higher-quality markets. Chart 12Global Corporate Bond Breakeven Spreads, Ordered By Percentile Ranks The main conclusion form the chart is that there is a lot of red on the left side and none on the right side. That means junk bonds in the US and Europe have relatively high breakeven spreads, while investment grade credit in most countries have relatively lower breakeven spreads. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. To further refine the cross-country comparisons, we must look at those breakeven spreads relative to the riskiness of each sector. In Chart 13, we present a scatter graph plotting the 12-month breakeven spreads versus our preferred measure of credit risk, duration-times-spread (DTS), for all developed market corporate credit tiers, as well as EM USD-denominated sovereign and corporate debt. The shaded region represents all values within +/- one standard error of the fitted regression line. Thus, sectors below that shaded region have breakeven spreads that are low relative to its DTS, suggesting a poor valuation/risk tradeoff. The opposite is true for sectors above the shaded region. Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) The sectors that stand out as most attractive in this framework are B-rated and Caa-rated US high-yield, and EM USD-denominated investment grade corporates. The least attractive sectors are US investment grade corporates, for both the overall index and the Baa-rated credit tier. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. Looking beyond the spread and volatility measures presented in this report, we must consider the default risk of high-yield bonds. Our preferred measure of valuation that incorporates default risk is the default-adjusted spread, which measures the current high-yield index spread net of default losses. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. The current US high-yield default-adjusted spread is now well below its long-run average (Chart 14). We expect a peak US default rate over the next year between 10-12% (levels seen after past US recessions) and a recovery rate given default between 20-25% (slightly below previous post-recession levels). That combination would mean that expected default loses from the COVID-19 recession could exceed the current level of the US high-yield index spread by as much as 400bps (see the bottom right of the chart). Given that risk of default losses overwhelming the attractiveness of US high-yield as measured by the 12-month breakeven spread, we prefer to stay up in quality by focusing on Ba-rated names within an overall neutral allocation to US junk bonds. For euro area high-yield, where default-adjusted spreads are also projected to be negative next year but with less attractive 12-month breakeven spreads, we recommend a cautious up-in-quality allocation to Ba-rated names only but within an overall underweight allocation. After ruling out increasing allocations to US B-rated and Caa-rated high-yield, that leaves the two remaining valuation outliers from Chart 13 - US investment grade and EM USD-denominated investment grade corporates. The gap between the index OAS of the two has narrowed from the March peak of 446bps to the latest reading of 259bps (Chart 15). We believe that gap can narrow further towards 200bps, especially given the supportive EM backdrop of USD weakness and China policy stimulus – both factors that were in place during the last sustained period of EM corporate bond outperformance in 2016-17. Chart 14No Cushion Against Credit Losses For US & Euro Area HY Chart 15EM IG Corporates Remain Attractive Vs US IG We upgraded our recommended allocation to EM USD-denominated credit out of US investment grade back in mid-July, and we continue to view that as the most attractive relative value opportunity in global spread product on a risk/reward basis. Bottom Line: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-08-10/u-s-junk-bond-market-sets-record-low-coupon-in-relentless-rally 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights We remain bullish on France over the long run. Its industrial economy should revive on global stimulus over the coming years and its government will likely remain reformist in orientation. Macron has enough of a popular consensus and enough time on the political clock to oversee recovery in 2021 and get reelected in 2022. It would take a massive new economic crisis, on top of COVID-19, to generate a successful anti-establishment challenge. Macron is not likely to enjoy the strong legislative majorities of his first term. Much depends on how he handles the economic recovery and the international challenges facing Europe. The likely leadership change in the US will assist on the latter point, although US policy uncertainty will weigh on France’s prospects in the near term. Investors with a long-term horizon should go long French defense and energy stocks relative to American peers, which face policy headwinds. Underweight French government bonds in a diversified portfolio over the long run. Feature France celebrated Bastille Day this year with a toned down military parade on the Champs Elysee. The COVID-19 pandemic has hit the country hard – it has the eighth highest death toll in the world with 452 deaths per million people. By comparison, the US is ranked seventh, with 472 deaths per million (Chart 1). Chart 1France Has Been Badly Hit By COVID-19 Ironically, the crisis provided President Emmanuel Macron an opportunity to postpone his controversial pension reform and put a stop to massive labor strikes. These strikes were surprisingly large and effective – much more significant than the Yellow Vest protests that erupted in 2018. Aggregate demand will benefit but France’s economic structure will not, until reforms get back on track. With less than two years before the presidential election, we take a moment to reassess our view on Macron’s re-election prospects and our bullish view of the country’s equity market. We view Macron as a favorite for re-election and hence remain optimistic about the prospects for structural reforms that improve France’s economic competitiveness over the long run. French Markets Have Underperformed Amid COVID-19 But Will Outperform Later Chart 2French Equities Amid Covid-19 French equities have underperformed developed market equities by 12% this year. The post-February equity rally, fueled as elsewhere by massive monetary and fiscal stimulus, has been disappointing compared to US and German equities but still better than that of southern European bourses Italy, Spain and Greece (Chart 2). France has also outperformed the UK, which is heavily reliant on energy and financials and faces a high degree of economic policy uncertainty due to Brexit. Our European Strategist, Dhaval Joshi, has described equity performance this year as a case of the “good stock market” versus the “bad stock market.” The key lies in the relationship between equity sectors and bond yields. For the good sectors, lower bond yields entail a valuation boom and higher prices – as with information technology and health care. For the bad market, lower bond yields entail a profits recession and lower prices – case in point being the banking sector. To better illustrate his point, Table 1 provides the sector composition for core European equities and other developed market bourses (US and UK) as well as the year-to-date performance of each sector. Banks have underperformed massively while information technology and health care have delivered positive returns across different bourses thus far. Table 1The "Good" And The "Bad" Stock Markets French equities are the most exposed to global growth, with 17% allotted to industrials and 4% to energy. Year to date, these sectors have underperformed by -24% and -34% respectively. The upside is that global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance during the virus lockdowns. Global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance. Extremely accommodative monetary policy around the world will keep bond yields low as long as unemployment stays high and inflation stays low. Central bankers will remain ultra-dovish. This will drive a search for yield from investors and bid up risk assets’ prices in the process. Core European government bond yields may fall further in the short run, in the face of a resurgent virus and acute geopolitical risk surrounding the US election, but not the long run (Chart 3). Reliable cyclical indicators such as the German ZEW and IFO surveys are already showing signs that Euro Area growth is starting to recover from the lockdowns. Chart 3The Threat Of Second Waves Will Keep A Lid On Bond Yields Chart 4French Bonds Will Underperform As Growth Recovers In relative terms, economies with high “yield betas” tend to have the greatest sensitivity to global growth indicators (Chart 4). We anticipate a revival in global growth sometime in 2021, as policymakers will be forced to apply more stimulus when needed. Bond yields will eventually rise, though there is a long journey before the output gap will be closed. French bonds will underperform their peripheral peers, which have more to gain from the global search for yield combined with the implementation of the Macron-Merkel agreement to mutualize Euro Area debt. Bottom Line: Fundamentals suggest that investors should go long French equities, and favor French over other developed market equities over a long-term investment horizon. Investors should remain underweight French government bonds in a diversified portfolio over the long run as the global recovery advances. The Bloated State Saves The Supply-Side Reformer Most lockdown restrictions ended at the beginning of June in France and most measures of economic activity have rebounded sharply. The French manufacturing PMI came in at 52.4 in July, a 22-month high, from 40.6 in May. The services PMI jumped well above the 50 boom/bust line to 57.8 from 31.1 in May (Chart 5). Firms are finally resuming business as usual alongside a marked improvement in sentiment regarding the next 12 months. The underlying data from the Markit PMI survey revealed that domestic demand drove the expansion. Chart 5Sharp Rebound In Soft Data Chart 6Don’t Judge The Recovery Based On The Fiscal Stimulus Package France’s rebound was sharp even relative to other developed markets that had deployed much larger fiscal stimulus packages (Chart 6, with details in Appendix). First, the French economy was surprisingly resilient during the 2019 manufacturing downturn and the slowdown in global activity – note that the French manufacturing PMI only flirted with the 50 boom/bust line in 2019 while German, Italian and Spanish manufacturing PMIs remained well below 50. Importantly, France is after Germany the European country that stands to benefit the most from the recovery in Chinese economic activity. Second, while France’s new fiscal spending was restrained overall, the composition of its stimulus and its existing automatic stabilizers proved to be effective. France rolled out one of the most generous state-subsidized furlough schemes in Europe, with the state shouldering more than two-thirds of wages and leaving the rest to the employers. By end of June, more than 13 million workers were on state-subsidized furloughs, almost half the French workforce (Chart 7). That compares with around one-third of workers in Italy, and around one-fifth in the UK and Germany. Going forward, the sectors most badly hurt by the COVID-19 crisis, such as aerospace and tourism, will be able to keep benefitting from state-subsidized furlough schemes for the next 24 months if necessary. For other companies, the coverage will be slightly reduced and extended into the first quarter of 2021. Reducing unemployment is essential for any world leader, but Macron faces an election around the corner, and he had promised specifically to bring unemployment to 7% by the end of his mandate. Before the crisis the unemployment rate was 7.6% but is now expected to reach 10% by the end of 2020 (Chart 8). Normally it takes eight years after a recession for French unemployment to return to pre-recession levels. Chart 7The French Furlough Scheme Is Impressive Chart 8French Unemployment Rate Expected To Jump Back To Post-GFC Peak In other words, Macron will do more stimulus if necessary. So far France’s coronavirus response measures amount to nearly 4% of GDP, excluding loan guarantees. An unprecedented public sector budget deficit of 11.4% is now expected by the government this year, compared to 3% in 2019. The government is supporting car manufacturer Renault and airline company Air France – two jewels of the French economy – as well as other industries. Given the V-shaped recovery, we would not expect banks to shut the credit tap (Chart 9). Indeed, the French economy will be able to rely on stronger bank lending activity than its European peers (Chart 9, panels 2 and 3). Importantly, Chart 10 shows that French companies rated by Moody’s are less extremely exposed to the pandemic-induced recession than the firms of neighboring Germany, Italy, and Spain. Further, once economic conditions improve enough to restore consumer confidence, then consumer spending will pick up, bolstered by accumulated savings (Chart 11). Chart 9Supportive Bank Lending Chart 10A Lower Exposure To The Pandemic-Induced Recession Tourism is a weak spot, but France’s reliance on tourism is overstated (Table 2). The sector accounts for 9.5% of GDP and 7.3% of non-financial business employment. France made supporting this industry a national priority.   Chart 11A V-Shaped Recovery In Consumer Spending Incoming? Table 2The French Reliance On Tourism Is Overstated Ironically, President Macron’s greatest asset right now is the large French state that he campaigned on cutting down to size. The French state helped sustain the economy better than others during this year’s historic shock. Bottom Line: France’s economic rebound has surpassed that of other countries that deployed larger stimulus packages. Gener­ous furloughing, large automatic stabilizers, ample bank credit, and Macron’s looming election ensure that government support will persist. This is a solid backdrop for an economic recovery led by domestic demand. Macron Still Favored In 2022 Chart 12France Gets A “C-“ For Handling The Pandemic & A “B+” For Handling The Economy The French people naturally question the ability of government authorities to handle the pandemic efficiently (Chart 12). By mid-May, about 60% of the public doubted the government’s effectiveness. Public opinion has not been so bad when it comes to the handling of the economy by the government (Chart 12, bottom panel). Moreover Macron has received a notable boost to his popular support during the crisis. The number of people who intend to vote for him has gone up, the first time that has happened for an incumbent president since 2002 (Chart 13). Compared to other world leaders, Macron fares pretty well. His personal support and his party’s support have increased more than their peers in Spain, the US, the UK, and Japan, albeit less than in Germany and the Netherlands (Chart 14). But while those two governments only have to sustain this support until next year’s elections, Macron needs to sustain support for two years to get re-elected. Chart 13The Crisis Ended Up Boosting Macron’s Popular Support... Chart 14…Which Is Not The Case For All Political Leaders The good news for Macron is that the public does not believe that any other parties or candidates would have handled the pandemic any better (Chart 15). There is a lack of credible opposition from traditional political parties. Macron and the anti-establishment Marine Le Pen, who leads the National Rally, are expected to face each other once again in the second round of the 2022 election. If the election were held today, polls suggest Macron would win this rematch with 55% of votes instead of the 66% he won in 2017. Chart 15French Public Does Not Blame Macron For Coronavirus Handling As long as voters are forced to choose between Macron and Le Pen, Macron has the advantage. As in 2017, he will be able to appeal to voters from other parties in the second round of the election, notably the green party EELV (see Box 1). Left-wing voters will join with center-right voters to elect him. The risk to Macron is if a viable challenger manages to edge out Le Pen. Or, an economic collapse could discredit his centrist and reformist movement and drive more voters into the anti-establishment camp. But that risk merely underscores the necessity that will drive his administration to play an accommodative and reflationary economic role. As long as voters are forced to choose between Macron and Le Pen in 2022, Macron has the advantage.  Box 1: Macron Suffers A Setback In Local Elections French local elections have historically been a way for voters to sanction the incumbent power, as was the case for Nicolas Sarkozy in 2008 and his successor Francois Hollande in 2014. True to the historical pattern, Macron and his party La Republique En Marche (LREM) performed poorly in the polls this year. Amid the virus, voter turnout was historically low: 41% compared to 62.1% in 2014. Macron has seen some splintering in his party and has been forced to reshuffle his cabinet. This stumble should not come as a surprise for a party that is akin to an infant in the French political landscape and therefore preferred to play it safe by endorsing candidates in only half of France’s cities of 10,000 people, often choosing to support right-wing candidates (Les Republicains) everywhere else. Fortunately for Macron, Marine Le Pen’s party did not fare any better. The main surprise from the 2020 local elections came from the green party Europe Ecologie-Les Verts (EELV) which even managed to win a number of major victories in large cities. A surge for the Greens is actually quite positive for Macron as he will have no trouble rallying the Greens in 2022 if he is opposed by Le Pen (Chart 16, bottom panel). This outcome also calls for an environmental spending push as part of stimulus efforts in the second half of his term. Chart 16Polls See Macron Win In 2022 Macron is still popular among Millennials, white collar workers, and the elderly (Chart 16). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, yet he still outperforms Le Pen among rural voters in today’s polls. Bottom Line: Macron is still favored to win the 2022 election. The two-round voting system makes it very difficult for a populist or anti-establishment politician to win the election, given that other factions will align against extreme players. While another massive economic shock could change things, the Macron administration will pursue economic reflation all the more aggressively to prevent this outcome. Macron Keeps France On Reformist Path Crises often accelerate the changes that were taking shape beforehand. This is positive for Macron’s centrist vision of France rather than the anti-establishment alternative that he faced down in 2017. What will be Macron’s roadmap for the remaining two years of his presidency? Public opinion wants him to focus on the labor market and the economic recovery in the months to come and he will be happy to oblige (Chart 17). Macron reshuffled his government before announcing a recovery plan of 100 billion euros, of which 40% will be funded by the European recovery fund. For now, we know the private sector will receive a large share of the pie in order to boost productivity and help French companies stay afloat. Twenty billion euros will go toward the environmental push. A detailed blueprint will be unveiled at the end of August. Chart 17Roadmap To 2022: Focusing On The Labor Market & Economic Recovery Structural reforms may not resume until after 2022. Yes, Macron intends to finish his pension reform prior to the election. And yes, he is capable of passing it through the legislature on paper. Technically he lost his single-party absolute majority in the National Assembly in May. Defections have cost him 26 party members since the 2017 election. But LREM can still count on the unconditional support of two other coalitions in the Assembly giving him 355 seats out of 577 (61.5%). However, Macron would take a huge gamble in reviving the pension reform when the country’s output gap is large. Former President Nicolas Sarkozy attempted to pass a less ambitious pension reform in the midst of the Euro debt crisis, 12 months before facing re-election in 2012 – and he lost the election. We doubt Macron will share the fate of his predecessor, but that most likely means punting on reforms for now and returning to them after securing re-election. If Macron proves us wrong, then that will be a positive surprise for French equity markets confirming our thesis that Macron is favored and France is on a reformist trajectory. The pace and breadth of the reforms have been substantial so far, but obviously Macron has halted plans to pare back the size of the state. Cutting back inefficiencies will still be a theme of Macron’s re-election campaign, but with modifications for the new political environment (such as green spending, mentioned above). Meantime, the COVID-19 crisis revealed that more state decentralization is desperately needed. We should also expect measures to push French companies to relocate production activities back into France, which will be more feasible thanks to labor reforms passed into law earlier in Macron’s presidency. The crisis revealed France might find ways to strengthen supply chains, starting with medical masks, of which France is a net importer. Excessive foreign dependency is an economic reality that the French president cannot envision for France and the EU. As Macron said, “The only answer is to build a new, stronger economic model, to work and produce more, so as not to rely on others.” The objective is to build a European Union that is less dependent on China and the US. The EU is first and foremost a geopolitical project, and the impetus for integration has increased, not decreased, since the 2008 financial crisis. A divided Europe is no match for Russia, the US, or China, especially if the US takes a step back from its post-World War II role of guaranteeing free trade and global security. While a Democratic Party government in Washington would ease trans-Atlantic tensions, there will still be an American need to limit foreign commitments and a European need to look after itself. The outstanding question, then, is the makeup of the National Assembly in 2022. This is too far away to predict. What is clear is that Macron is unlikely to regain the golden single-party majority with which he entered office in 2017, or to gain control of the Senate. So he will necessarily be more constrained in a second term in the legislature. Nevertheless he will still benefit from the underlying trend in France: the demand for a better economy and jobs market. This requires pro-productivity reforms, which is known by the public, and Macron has made reform his banner. Bottom Line: Overseeing the economic recovery and bringing down unemployment will be the two key factors to monitor. At present, Macron’s chances of re-election are good. He does not face a major challenger other than the anti-establishment Marine Le Pen, who will provoke a coalition of parties against her. He even stands to benefit from the rise of the Greens, although the future makeup of the legislature will then become the key challenge. Although the focus of the remaining two years of his mandate will be on economic recovery, there is a chance that Macron could pass a watered-down pension reform. This political setup is positive for French growth but not entirely at the expense of long-term productivity. After 2022, Macron will face a higher legislative constraint, but he will have a new mandate to pursue structural reforms. Investment Takeaways Governments and their populations do not have much appetite for additional social lockdowns as COVID-19 cases reaccelerate, but lockdowns are clearly a near-term risk to the recovery. As such, risky assets face volatility in the near term. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. The EUR-USD is reaching a critical testing ground (Chart 18). European integration has taken another leap forward during this crisis, thanks in part to Macron’s diplomatic success in smoothing the way for Germany’s Merkel to take prompt steps toward joint debt issuance and more proactive fiscal support for the periphery. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. Chart 18The Case For A Higher EUR/USD However, the dollar could bounce in the near term. A chaotic US election is looming in three months and European earnings revisions underperforming the US will weigh on the euro. While global growth is recovering, and a massive new round of US fiscal stimulus is likely to further enlarge US twin deficits, the 35% chance of a surprise Trump victory would raise the prospect of trade war against Europe as well as China in 2021 and beyond. The dollar could revive if the market seeks safe havens on the anticipation of new crises in a second term in which President Trump is “unleashed.” This would also hurt industrial-oriented economies like France. The risk scenario of Trump’s re-election would also increase the tail-risk of a major conflict with Iran over the subsequent four years – and Middle Eastern instability is negative for European risk assets and political stability. Therefore the long EUR-USD call could be jeopardized by a surprise as November approaches. Otherwise, assuming that the Democratic Party wins the US election, the risk of a trade war against Europe will collapse. So too will the risk of a real war with Iran. Meanwhile the US’s strategic pivot to Asia will be handled in a less disruptive way. Therefore EUR-USD would stand to benefit. To the extent that European equities tend to outperform other regions only when global growth is accelerating, bond yields are heading higher, and the growth defensives like tech are underperforming, we are inclined to underweight European bourses relative to US equities in the short run, but not the long run. On a cyclical or 12-month-plus time frame, governments are likely to succeed in rebooting economic growth through massive stimulus. This is positive for French equities, particularly relative to US equities. We recommend going long French aerospace and defense equities in particular. This sector has been beaten down, like its global and American peers. Yet geopolitical power struggle will fuel defense expenditures and global stimulus will revive the aerospace sector once the coronavirus becomes more manageable (Chart 19). Tactically, the shift to a Democratic administration in the US presents near-term risk for US defense stocks, making them the fitting short end of a pair trade favoring French defense stocks. Two French sectors equities are particularly attractive: Aerospace & defense and Energy. Tactically we would play these against American counterparts due to US election policy headwinds for defense and energy. We also recommend going long French energy equities, relative to US peers. The French energy sector has been outperforming its US and developed market counterparts in recent years and will benefit from a global growth revival (Chart 20). The sector will also benefit on the margin if Trump loses the vote and cannot pursue “maximum pressure” on Iran, but instead gives way for former Vice President Joe Biden to tighten regulation on US energy companies and restore the 2015 nuclear deal and strategic détente with Iran. Chart 19Go Long French Aerospace & Defense... Chart 20…And Long French Energy Relative To US We remain bullish French equities on a secular basis as long as Macron’s reelection remains the base case, European integration is supported and France has the prospect to return to incremental structural reforms over time. Meanwhile it is an economy that is structurally protected from the world’s retreat from globalization. De-globalization abroad requires Europe to break down internal barriers and France is well-positioned to succeed in such an environment.   Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Appendix