Structural reforms in Italy? Pro-business policies in France? Ask any investor if these were likely a year ago, they’d almost surely have said no. Italy is gridlocked! France’s President is a Socialist! But reality often enjoys taking an ironic turn. Italy’s firebrand new Prime Minister is shaking things up with a new reform-minded budget, and France’s new cabinet is continuing President François Hollande’s drive toward moderation. How far either initiative gets remains to be seen—it’s politics, after all!—but both illustrate how investors operating on political biases and assumptions alone often end up blindsided by a better-than-expected reality.
Our tale begins in Italy, where new PM Matteo Renzi has promised ambitious economic reforms since his February appointment. But save for some local government bloat-trimming and the 151 ministerial luxury cars hawked on eBay, it was all talk until Tuesday’s three-year budget agreement. Considering Renzi has spent months calling for looser fiscal policy to boost growth and famously called the EU’s budget stability pact a “stupidity pact,” most expected some growth spending plans. But Renzi took a different tack. Along with €7 billion in tax cuts for lower-income workers—the largest tax cuts in two decades—came €5 billion in spending cuts to reduce Italy’s public debt and comply with the EU’s 3% debt-to-GDP limit. And topping it off was acknowledgment 2014 growth will likely slow from initial projections of 1.0% to just 0.8% as a result.
Counter-intuitively, this is an encouraging sign. It indicates Renzi is in it for the long-haul, resisting the urge for a short-term fix in order to undertake structural reforms—and accepting slightly slower growth in the near term as a tradeoff for building a foundation for more sustainable growth. Renzi’s proposals probably aren’t big enough to bring about some earthshattering changes that turn Italy into, say Germany, and it’s a three-year plan. But hey! You’ve got to start somewhere. The same goes for the labor reform efforts Renzi launched last week, which includes plans to revamp the unemployment welfare scheme, improve employment agencies and establish a new employment contract that eases some of the restrictions on employers. Here, too, it’ll be a slow-go. Renzi estimates it’ll take up to a year to pass the legislation given the many vested interests in the way. But if politicians see things through, Italy would benefit over time.
As ever in politics, however, there is an IF. Lawmakers are presently locked in a squabble over election reform, and the budget could get caught in the crossfire. The reform plan agreed by Renzi and former PM Silvio Berlusconi in January is in jeopardy. Measures to change how seats are awarded in the lower house passed that chamber last month, but they’re still pending in the Senate—as is part II, the measures to strip the Senate of most of its powers in order to streamline the legislation process. Renzi staked his political future on this, saying the plans are nonnegotiable and he’ll quit if they fail. Soon after, Berlusconi reneged. It could still pass without his support, as Renzi’s Democratic Party and its coalition partners have enough seats, but if more than a dozen or so senators rebel, they’ll need Silvio.
So for now, the politicking continues—and gridlock might. But Italian stocks have proven since last summer they can do just fine amid gridlock. And if the budget moves forward, it’s an incremental positive.
On the other side of Mont Blanc, French President François Hollande replaced some members of his cabinet after his Socialist Party took a thumping in local elections, where voters flocked to the far and center-right. Heading the cabinet is new Prime Minister Manuel Valls, a self-proclaimed admirer of former UK PM Tony Blair—the man responsible for moving the Labour Party away from its long-held Socialist platform and toward the free market.
Overall, the appointment seems to be yet another sign Hollande is moderating and isn’t the anti-business guy so widely feared when he became President in 2012. His campaign-trail rhetoric was certainly socialist, but these days his policies are anything but. In January, Hollande announced a “responsibility pact” aimed at cutting public spending to reduce the deficit, slashing €30 billion in “family allowance” payroll taxes and offering tax incentives in exchange for commitments to meet hiring targets. Markets cheered, but the Socialist Party wasn’t entirely on board. Now, in Valls, Hollande has a market-friendly lieutenant with the clout and drive to rally the troops.
Now Valls seems to be off and running with the baton. On Tuesday, he announced a raft of tax cuts and labor reforms, and the National Assembly rewarded those proposals with a 306-239 confidence vote. In addition to reiterating the already-announced payroll tax cuts, he proposed ending the requirement for companies to pay payroll taxes for minimum wage workers and reducing taxes for low-income workers.
As with Italy, the proposed changes probably won’t turn France into the world’s most competitive economy overnight. But they don’t need to for French stocks to do fine. With most investors still seeing Hollande and the Socialists as anti-market, moderation is a positive surprise for stocks—and likely, in our view, a key reason French stocks have outperformed since Hollande was elected. That doesn’t mean they keep outperforming from here, but it does suggest those expecting France to tank just because a Socialist is in the Elysée Palace likely have another thing coming.
Of course, what happens in either case remains to be seen. But what matters more for investors now is that political drivers in two of Europe’s biggest economies are shaping up better than many expected.