Is positive investor sentiment towards Europe misplaced?

Following the re-election of Angela Merkel in Germany and the victory of Emmanuel Macron in France, it might seem as if Europe has survived populism. Economic growth is broadly improving in Europe, and investment analysts view the region favourably again. But is optimism on the region justified? 

The primary cause for the return of populist politics – which overpromises undeliverable policies with mass appeal – is often said to be high inequality. In the US, UK and parts of Europe, stagnant economic and wage growth, together with increasing cultural diversity, have paved the way for Brexit and president Trump. 

Now that the European economy has improved, optimistic views are voiced based on the assumption that a growing economy will push up wages, which will in turn shrink the income gap.  But while the traditional indicator of inequality, the GINI coefficient (which measures the extent of wealth distribution of a nation’s residents), suggests the income gap and therefore inequality have shrunk in the UK, James Butterfill, head of research and investment strategy at ETF Securities, believes this is potentially misleading. 

He says that inequality is notoriously difficult to measure, and that the GINI coefficient is insensitive to the differences between the richest and the poorest. 

He argues that ‘populism is associated with the ordinary man being oppressed by a remote elite, and therefore a metric for inequality such as the Palma ratio is more appropriate, as it measures the ratio between the top 10 per cent of earners versus the bottom 40 per cent.’ 

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He explains: ‘Gabriel Palma, who developed the ratio, implied in his work that globalisation is creating a distributional scenario in which what really matters is the income share between the rich and lower income workers with ever more precarious jobs in ever more “flexible” labour markets.’

When applied to Europe, what the Palma ratio highlights is that some of the greatest inequalities in the OECD are places where we have witnessed some of the most significant populist uprisings. Therefore, says Butterfill, inequalities have not necessarily disappeared. Instead they could continue to fuel the next round of elections. 

Chris Hiorns, manager of the Amity European fund at EdenTree, adds that post-German elections, ‘the big test yet to come is Italy.’ 

Last December when Matteo Renzi lost the referendum, ‘risk premiums went up. And it’s perfectly conceivable we will see that happen again over the next six months.’ He adds that he has already reduced his exposure to Italian equities. 

With Spain’s violent reaction to Catalonia’s declaration of independence, the UK’s chaotic Brexit negotiations, and the rise of the anti-immigration party Alternative for Deutschland (AfD) in Germany, political uncertainty is set to continue in Europe.  

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