After the political tsunamis of 2016 —with the unexpected decisions by the British to leave the EU, and the Americans to elect Donald Trump president— the political nexus in 2017 shifted to the Eurozone. After the Dutch vote, it's not the turn of France and, later this year, Germany —both vulnerable to the rising populist tide.
The immediate focus is on France, which is seemingly vulnerable to political rebellion. What is the likelihood of success for the anti-establishment parties? What are the implications of such success politically? And what will it mean for financial markets? Let's look at the first election:
The presidential election is a two-round process, designed as such to prevent ‘extreme’ candidates from capturing the presidency. The two candidates with the largest number of votes from the first round on 23 April will face off in the second-round vote on 7 May. Currently, there are 10 declared candidates, five of them realistic candidates. The left wing is represented by Jean-Luc Melenchon (La France Insoumise) and Benoit Hamon (Socialist Party), with centre right and far right by Francois Fillon (Republicans) and Marine Le Pen (Front National), respectively. Former socialist and new party founder Emmanuel Macron (En Marche) bestrides the centre.
The candidates currently commanding around 20% or more in the opinion polls are Macron, Fillon and Le Pen—with Melenchon and Hamon commanding between 10% and 15% each. The winner of the contest is likely to emerge from the former three. However, if Melanchon and Hamon come to an electoral arrangement, with the latter the likely front man, such that the far left are unified—the probability is that the far left moves up to 25% in the polls, blowing the race wide open.
Le Pen has been static in the polls over the last few months at 25%. This has historically been enough to ensure passage to the second round. Both the markets and commentators believe that she will definitely be in the second round. Who she will face, however, is up for grabs. After the emphatic victory by Fillon in the Republicans primary in November, it looked as though he was assured of contention in the second round.
Since the emergence of ‘corruption’ allegations, particularly in the payment of public funds for allegedly questionable employment of his wife and children, his support has eroded substantially. With Macron then declaring and entering the race, the centrist vote has had an alternative which has boosted his ratings. At present, the likely run-off contender against Le Pen will emerge from these two. However, Fillon being forced to withdraw from the race cannot be ruled out. After Alain Juppe ruled himself out of replacing Fillon for the Republicans, a new candidate may emerge to upset the electoral arithmetic. However, the deadline for this to happen is 17 March, thus the room for manoeuvre is limited.
Assuming Fillon remains in the race, as is his declared intention, based on current polls either Macron or Fillon should comfortably defeat Le Pen in a second round run-off—although the recent scandals to engulf Fillon has seen his potential margin of victory narrow to 14%. Even with the electoral surprises of last June and November, it is difficult to imagine the leads shown here will be eliminated by ‘shy’ Le Pen voters. However, it is not inconceivable that things could change if an exogenous event, such as another terrorist attack, occurs near polling day.
A more plausible route to a Le Pen victory would be if, as mentioned previously, the far left unite under a single candidate (Hamon), taking his vote towards the 25% level, squeezing out the two centrists. In such an environment it is hard to call which way the centre vote would fall. A victory for Hamon/Melanchon or Le Pen in a second-round runoff would, in our opinion, eventually be detrimental to French assets.
If it is Macron or Fillon in the second round against Le Pen, we expect whichever of the former two qualifiers will win. This, on the other hand in our view, would be a positive for French assets given the underperformance they have suffered over the last three months and we would envisage French bonds to tighten relative to their German counterparts. A Fillon victory would be a more long-term positive given his pro-business agenda which, if implemented, should begin to address the long-term structural and competitiveness problems that France has. Macron would be less economically positive given his more centrist agenda.
If the Far Left unites behind a single, unity candidate and squeezes out both Macron and Fillon in the first round, the outcome is clearly very negative for French assets as the likelihood of a Le Pen victory rises substantially. If Hamon/Melanchon win, some relief rally may occur given their pro-European stance, however, their economic program would only worsen the problems France faces—meaning that any retracement in French bond spreads to early 2016 levels is unlikely.
A Le Pen victory would be unequivocally negative as it would combine an anti-EU program with an antireform domestic economic program. French bond spreads should widen sharply. However, it must be borne in mind that it is highly questionable how much of the Front National program would be enacted. While the President has wide-ranging powers, they are limited by the Prime Minister and Parliament, particularly in the House of Representatives. Le Pen’s party has only a small representation in the latter and even with elections to the chamber following closely on the Presidential election, the electoral system is such that it will be very difficult for the Front National to meaningfully increase their numbers, let alone be in a position to appoint one of its members Prime Minister. This is crucial, as under the French Constitution only the Prime Minister or either of the chambers of Parliament can initiate a referendum (on the EU). With political deadlock, French asset (and indeed all peripheral European) spreads are likely to widen due to the uncertainty, but it will take markets quite some time to fully price in a break-up of the euro.
We have had a negative view of French assets for a number of years because of the structural challenges to the French economy and the lack of desire to confront them. We have favoured German and Belgian bonds instead. Post the election of Donald Trump in the US, we thought French risk premiums could rise further, believing the election uncertainty in an increasingly populist world was not priced in. We will continue to maintain this position until we believe spreads more adequately compensate us for the risks entailed. Depending on the evolution of opinion polls and the first round of the presidential election, that would be somewhere north of 100 basis points against Germany on a spread basis.