This weekend was very important for the very existence of the Euro Zone. Two troubled countries of the fiscal union had elections, and things aren't looking good for either. At least we know that Germany will not be happy with the results. From the looks of it, François Hollande will not go along with Germany's desires. Germany wants to cut social spending in European nations; Mr. Hollande wants to increase it in France. Earlier this week, Angela Merkel openly endorsed Nicolas Sarkozy, and she has many views clashing with those of Mr. Hollande.
After the PIIGS (i.e., Portugal, Ireland, Italy, Greece and Spain), France is the next country under risk of not being able to pay its debt off. Government spending, particularly social spending, accounts for much of the country's economic activity, and this is making the matters worse for the country. I personally don't agree with solutions that rely on austerity alone and don't focus on growth oriented measures. If 60% of a country's GDP is government spending and the government cuts its spending by 10%, the country's GDP will shrink by about 6%. In order to make up for this loss, the country's private sector has to achieve tremendous growth just for the GDP to get even. However, increasing social spending is not the option either. That's what got these countries in this mess in the first place. Why would a country want to go back to something that didn't work in the first place?
France's current debt to GDP ratio is about 89% as of the first quarter of 2012. This ratio was expected to pass 100% by 2017 with Sarkozy as the president. Now we can expect the ratio to pass 100% by an earlier date, because Hollande isn't bothered at all by France's debt problem. Hollande wants to balance France's budget by 2017, and he relies on increasing taxes for this goal. The problem is that France already has very high taxes to begin with. If your government relies too much on taxes, one thing you don't want to do is to scare rich people away from your country by taxing them to death as this may lead to an exodus of tax payers and shrinkage of tax revenue for the country. France currently has multiple types of taxes. For example, the government collects 0.55% annual tax for assets valued between $1 million and $1.5 million, while the rate increases to 0.75% for assets valued between $1.5 million and $3.3 million, to 1% for assets valued between $3.3 million and $5.2 million and so on. Coupled with social tax, the income tax can go as high as %50 of one's gross income depending on income levels. Sales tax exceeds 20% for many items and even gifts can be taxed based on their value. While taxes are so high in this country, there is very little room for increase without driving the population crazy.
If bond investors perceive that France will not be able to pay off its debt, France's bond yields will increase even more. Currently France's short term bond yields are very low but the long term yields are climbing. For example France's 1-month yield is 0.12%, 3-month yield is 0.08%, 6-month yield is 0.14% and 9 month yield is 0.17%. On the other hand, France's 5 year yield is 1.58%, 10 year yield is 2.82%, 15 year yield is 3.29% and 30 year yield is 3.60%. The 30-year yield can easily go above 5% if investors lose confidence that France will be able to pay its debt off in the long run. France's future budget planning (between 2012 and 2017) assumes a short term yield near 0 and long term yield around 3%.
Specifically, what are Hollande's plans for the budget of France? First of all, Hollande wants to cut France's dependence on nuclear energy and move the country towards cleaner, but more expensive options such as solar and wind power. This move can initially create a lot of jobs in France, however it will be very costly for the French government that's already buried under so much debt. Some of Hollande's tax proposals include increasing tax rate to 45% (on top of 12% social tax) on individuals that earn more than $200,000 per year. Also, tax deductions will be capped at $13,000 per individual per year regardless of income level if Mr. Hollande gets what he wants. Furthermore, Mr. Hollande wants to hire more government employees. He wants French government to fund construction of 150,000 homes for low income individuals and hire an additional 60,000 teachers. Moreover, Mr. Hollande gained a lot of popularity when he announced that he will reduce the retirement age back to 60 after the elections.
In Greece, things are looking even tougher. According to today's elections, there will be a coalition of multiple parties that do not share the same goals and values. I expect to see a lot of fighting and bickering in the Greek parliament in the next few years and I expect very few agreements coming out of the building. There will be a lot of decisions made by the Greek parliament that Merkel won't like in the coming years.
What does this mean for the investors? I expect a volatile summer coming up, similar to the last summer. We will hear a lot of news coming out of Europe, with some being good and some being bad. If the alliance of Germany and France falls apart, there is nothing in the way of collapse of Euro. I don't think it is going to be a quick and painless death either. For the next few years, we will hear a lot of fluctuating news. One day we will hear that debt problem can't be solved, and the very next day we will hear that the leaders have come to a solution. During the summer S&P (SPY) and other indexes may see last year's lows once again. I would stick with defensive stocks with solid dividends such as Exxon (XOM), AT&T (T) and P&G (PG). I would also keep some cash on the sideline in case some attractive valuations come up during the "down" days.
On a final note, investors of French companies such as France Telecom (FTE) may see a higher rate of tax withholding in their dividends in the next year or so. This was one of Hollande's promises prior to the elections.