Political risk is perceived as a major risk for the global stock markets. It's a well-known risk in emerging countries, but relatively new in the developed world considering that until recently, developed country politicians had conveyed a fairly strong pro-globalisation bias. The deck has been reshuffled, however, and the next key political event – the French presidential election – is seen as potentially disruptive should an anti-European candidate come forward.

But the rationale behind this perception is incomplete, in our view, which is something we feel we need to stress, because a candidate who is too pro-European would also come with a fair share of risks. Of course, any country that leaves the euro zone ultimately generates systemic risk, but the global markets would face a different type of risk if a pro-European candidate took the helm and revolutionised European governance in favour of...Europe, and thus steering it away from the United States. Even if the likelihood of these two extreme risks is low, it's important to bear in mind the consequences of a European nationalist policy on the equity markets.

The underlying issue at stake is the current distribution of listed company revenues and profits. To put it simply: the current distribution of profits is extremely lopsided and completely benefits US companies.

This can be illustrated as follows:

The US accounts for 4% of the world population and 24% of global GDP, but 52% of MSCI World profits!

Obviously, the initial reaction is to criticise the methodology: the United States is a highly-developed market economy with a much larger number of listed companies than other countries, so it's not surprising to see more of its listed company profits represented on the index.

This is a minor bias, as we see it, and we have a different interpretation. We see two main reasons for this outcome:                

  1.  there is a larger percentage of highly profitable companies in the US. Just look at RoE on the US flagship index, the S&P 500 (estimated at 16.3% in 2017), which largely exceeds that of the Stoxx Europe 600 (8.4%) and Japan's Topix index (7.0%).
  2. US companies generating the largest profits have successfully exported their national leadership (Apple, Google, JP Morgan, Microsoft, Johnson & Johnson, Facebook, Pfizer, General Electric, Intel, IBM, Cisco Systems, etc.).

The bottom line is: US super-profits tend to come from unprotected sectors. That's a fact. One that can be demonstrated by observing the opposite reality: in protected sectors such as telecommunications and utilities, you don't see US companies boasting super-profits. Beyond a potential innovative edge, US companies enjoy access to foreign markets that has skewed global profits to their advantage.

So why haven't European companies benefited to the same extent? Well, they have, but Europe missed the crucial technological turning point with the advent of the Internet.

As everyone knows, Europe is an economic heavyweight, but a political lightweight. Its economic weight is substantial when you add up the individual economic weights of its constituent countries. The European market is still very extensive, but if we look at European manufacturers, they predominantly consist of national champions (Daimler, LVMH, Nestlé, BASF, etc.) that have risen to the status of European champions by default. With the exception of the aircraft sector (Airbus), there is no real industry-wide policy aimed at establishing true European champions. Ironically, that was one of the founding ideas of Europe, with the ECSC (European Coal and Steel Community) in 1951.

With the third technological revolution (the Internet), the impact of the lack of such a policy was huge, impeding the emergence of any technological leaders in Europe. We've all seen the result: the Information Technology sector accounts for a ridiculously small share of profits in Europe.

Europe still has its national champions, but they hail from the old economy, whose profits are on the decline. Europe is not focused enough on the future, and by offering its market to the Americans, it is mortgaging its future that much more.

According to the chart below, in the space of 10 years, US companies have significantly increased their share of global profits. The problem is deeply ingrained.

China is an interesting case because it has been at least partially successful in protecting its market from US leaders. As it stands, China has its national champions in the information technology sector that can rival Facebook, Google, Amazon and the like.

Europe did nothing to stop Google from dominating the domestic market, when it would have been very easy to do so legally and push a European leader to the forefront (French search engine www.qwant.com, for example). The US leaders of the new economy set up shop in Europe free and clear, and the controversy surrounding taxes owed by Apple and Google in Europe is a bitter reminder.

Commentators have pointed out that a weak and divided Europe is a major financial risk. That's not completely accurate, as we see it. It may be true for bonds, because it undermines the possibility of mutualizing the European sovereign debt risk, but it's false for equities. As long as Europe is politically weak, it will never have the resources to counter the supremacy of US companies, and global profits will continue to skew in their favour. The political entanglement in Europe is an opportunity for the global equity markets because it is supportive for Wall Street. The European political divide serves to sustain US corporate profits.

However, should a French or German political leader decide to promote a European-centric industry policy by and for Europe, it would be a disaster for the equity markets in that it would definitely impact the profits of US megacaps. The biggest risk for Google is not a US recession. The real risk for US companies would be the emergence of a “European Donald Trump” eager to tax their European operations. The impact would be much stronger.

To sum up: ideally for Wall Street, the upcoming elections in Europe will result in a status quo, i.e. the election of candidates who do nothing to change Europe, with the ECB still in charge of keeping systemic risk under control.

 

Tristan Abet

Senior Fund Manager




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