Sea Change in France Triggers Sell-Off

Asian and European investors’ first response to the weekend election in France (and Greece) has been to run for cover. This theme will likely be the dominant driver of market action today in the U.S., as it did in Europe and Asia as the new week got underway. But does this reaction make economic sense or is it just another sign of a collective knee-jerk response from investors worldwide?

It does make sense, and here is why:

The response of Euro-zone leadership, which basically means Germany and France, to the region’s mounting financial crisis over the last three years has been to institute measures that will restore market confidence. The most important of such confidence boosting measures has been to cut deficits through tough austerity measures. The premise behind this policy line is that the implementation of a deficit reduction plan will demonstrate to the markets the country’s ability to pay back its debts.

The only problem with this otherwise reasonable logic is that implementing fiscal austerity in a backdrop of economic weakness exacerbates near-term growth. The ongoing recession in the Euro-zone is a direct result of this policy. It becomes politically difficult to sustain such policies in the face of widespread economic hardships. Electoral defeats for incumbent governments across Europe is evidence of this trend.

France has been a willing partner to Germany in pushing this policy prescription. But the election of Francois Hollande in France this weekend -- who ran on a traditional leftist pro-spending platform -- represents the first credible challenge to this German-inspired fiscal orthodoxy. It is not unreasonable for the markets to be concerned about the prospect of discord at the top of Euro-zone leadership, and that’s precisely what today’s worldwide market sell-off is reflecting.

Europe aside, it is fairly quiet on the domestic front, with the first quarter earnings season winding down and nothing major on the economic calendar. For the 84% of S&P 500 companies that have already reported, total earnings growth is tracking 6.5%, with roughly 67% coming out with positive earnings surprises. Most of the growth is coming through revenue gains, with aggregate margins essentially flat from the year-earlier level.

This is a far cry from pre-season expectations, when aggregate earnings were expected to be down modestly from the year-earlier period. Of this morning’s major earnings reports, we got better-than-expected results from Dish Network (DISH - Analyst Report), Tyson Foods (TSN - Analyst Report) and Avis Budget Group (CAR - Analyst Report).