What’s next for Europe after Merkel’s win?

Despite Angela Merkel’s victory in the recent German election, the increased level of support for extremist parties has some investors worried, writes Franklin Templeton’s Peter Wilmshurst.

: By Peter Wilmshurst; Tuesday, 10 October 2017

Angela Merkel’s victory in the German general election was probably not a surprise to most investors.

I think the market will be particularly concerned at the support for the populist Alternative for Germany (AfD) party, which secured seats in the Bundestag for the first time.

Some may see the AfD’s rise as a re-emergence of the sort of populism that we saw expressed in the UK Brexit vote and to a degree in the US presidential election.

However, we view this as just one election and think there are reasons to be optimistic from an investment standpoint.

Several core euroland countries are approaching full employment, and with labour capacity starting to tighten, we’re starting to see wages rise.

A widespread economic recovery in Europe should take the wind out of the sails of populism, because political activism has traditionally declined as more people begin to see their lot improving.

Already we perceive European corporate earnings to be in the early stages of a recovery. If we look at the macro backdrop, unemployment across the eurozone is at eight-year lows, while manufacturing leading indicators are at six-year highs.

Earnings recovery starting to come through

This positive backdrop is helping to underpin the corporate earnings recovery that we’re starting to see come through.

The second quarter of 2017 was the first quarter since the 2007-08 financial crisis that euroland gross domestic product (GDP) growth was ahead of that of the US.

With that in mind, we would expect investors could start to unseat themselves from the more defensive areas of the European market.

In time, we’d expect investor focus to switch to more cyclical companies, such as banks, insurance companies, even energy companies and industrials. These are areas in which we’d expect to see some opportunities.

Many of these more cyclical companies are growing earnings from a low base and currently have valuations reflecting that.

What’s next for inflation?

Meanwhile, the great missing feature for the equity market in general is inflation.

Currently, both the US and Europe are experiencing growth without inflation. We’d expect even a mere whiff of inflation to exacerbate the cyclical trends we see.

There are some suggestions eurozone inflation is on an upward trajectory, both at the consumer- and producer-price levels. Recent indications of strong consumer spending lead us to expect headline and core inflation should likely continue to move up.

Furthermore, over the past couple of years, we’ve seen inflation fears tend to stoke up and come through at the back end of the year.

Traditionally in Europe, when inflation does start ticking up, earnings start coming back at a faster rate than in other parts of the world. This is due in part to the large proportion of financials and commodity companies in Europe.

We’d expect to see earnings improvement quickly coming through in stock prices.