Some worry about a political tsunami. But so far, it looks like a four-way tie. The least likely outcome, a Le Pen / Mélenchon run-off, could trigger significant market volatility, providing attractive opportunities for astute investors.
We reaffirm our belief that while turbulent, the next few weeks will offer opportunities for a value manager such as Western Asset. Given the magnitude of shock that a Le Pen victory would entail, however, it's wise to review the constraints she would face in attempting to challenge the whole Euro project.
What’s coming? A quick reminder
On Sunday April 23, the French people go to the polls for the first round of a two-round election to choose their President of the Republic. The first round will whittle the 11 registered candidates down to a final two, who will fight it out two weeks later on May 7. Parliamentary general elections follow quickly, on June 11 (and 18 for the runoff).
The winner will be reliant on the support of the French Parliament for many key issues, most notably any significant change in France’s relationship with the European Union (EU). Only the Prime Minister (PM), or a majority of either chamber of the Parliament, can call a Referendum on EU membership; none of the most extreme candidates (far-right Le Pen or far-left Mélenchon) look likely to have enough support in the Lower House of Representatives, to appoint a PM from their party. But the Parliamentary general election could create renewed uncertainty.
What’s happened in the past month?
Over the past few weeks, opinion polls have been incredibly dynamic, highlighting the unpredictability of the election outcome, undoubtedly one of the most fractious in recent French history. What seemed to be a two-horse race between Le Pen and Emmanuel Macron, the Centre candidate, has turned into a four-way contest; at the time of writing the top four candidates (Le Pen, Macron, Fillon, Mélenchon) are all within 4 to 5 points of each other. Furthermore, turnout is expected to be relatively low at around 70%, which is thought to benefit non-mainstream candidates.
What does this mean for markets?
As we explained in Europe Decides: Elections, 2017, any of the four prospects would likely impact French asset prices. In some cases, there would be a broader implication for EU-wide assets, including Italian and peripheral bonds, as well as the euro currency. Clearly the change in the balance, from two clear final-round candidates, to the prospect of any two from four, has increased the likelihood of more market-unfriendly outcomes, including a Mélenchon–Le Pen second round. The candidates occupy the full spectrum of economic, social and political policies as one would expect.
But in the case of the relationship with Europe, while Mélenchon emphasizes the need to strike a new deal for France in the EU, only Le Pen really threatens a significant change, and even so, would be restrained by the likely outcome of June’s Parliamentary election. It is also important to note that with the UK continuing its plan to leave the EU by triggering Article 50, all four candidates will be engaged in “renegotiating” France’s role in the new post-Brexit Europe.
How have markets behaved?
While it’s impossible to extract the other influences on markets, including events on the geopolitical stage, it’s likely that the uncertainty of the French elections has at least enhanced the trends we saw in place in March. French bond spreads relative to Germany have widened to their post-2012 highs, but there are very few signs of true stress in cash bond markets.
Perhaps the clearest evidence of stress comes from the currency markets. Recent data released by the Bank of Japan shows Japanese investors’ net sale of ¥1.5 trillion (€13 billion) of French bonds during February, the largest monthly sale in five years. However it is thought that they continue to hold significant exposures to French and other European bonds, although sales may have continued into March.
This may explain the fact that the currency options markets1 are signaling that the cost of insuring euro exposures has been increasing sharply, as witnessed by the growing preference for euro puts relative to equivalent-delta euro calls. This preference, in terms of the implied volatilities charged for options on euro/yen, is back at levels seen during the height of the Euro Crisis in 2012, when European Central Bank (ECB) President Draghi promised to do “whatever it takes”.2 However, when looking at the broader influences on peripheral bonds, the response has been somewhat muted, as we expected.
What all this mean for strategies: Have we changed anything?
We have had a negative view of French assets for a number of years from a fundamental economic point of view. The structural challenges to the French economy and the lack of desire to confront them, particularly under the presidency of Francois Hollande, have led us to be pessimistic about French bonds for dedicated European investors. Post the election of Donald Trump in the US, we thought French risk premiums had to rise further, believing the election uncertainty in an increasingly populist world was not priced in. We will continue to maintain this belief until we see spreads more adequately compensate 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.
We continue to expect the ECB to support EU assets, alongside the robust growth trends we see in Europe. Provided they maintain their reform agenda, we feel Italian bonds already compensate investors for the heightened political uncertainty in France. Our key ballast against an increase in volatility remains a long US duration stance, with a bias towards 30-year US maturities. In the absence of a Le Pen or Mélenchon win on May 7, we expect German government bonds to underperform as eurozone political uncertainty wanes. Finally, with the euro currently trading at the lower end of the range versus the US dollar (that it has held for two years), we feel political risk ahead of the upcoming elections is now likely already factored into the euro’s valuation vs. the US dollar, and now believe a more neutral, modestly long approach is warranted.
The risks have clearly broadened, with four prospective candidates increasing the number of market-unfriendly scenarios. The consensus expectations are that the first round will see Macron and Le Pen pass through to the second round, and that a Macron victory should be expected. Fillon’s presence in the second round would be a surprise but cannot be fully disregarded.
In the unlikely case where either Le Pen or Mélenchon becomes president, significant uncertainty will linger. However, we'd continue to believe it would be very difficult for either to follow through with promised renegotiations or an EU referendum.
The prospect of a sweeping success for Le Pen’s party at the general elections, while of low probability, would be an event of tectonic magnitude, entertaining perhaps the full breakup of the Euro project, though it would take markets quite some time to fully price in such an outcome. As a result, we anticipate the elections will provide attractive opportunities for astute investors. But we remain vigilant, since these days have shown extreme events to be more likely than previously expected.