Outsider vs. outsider

French Election

Outsider vs. outsider

With the Presidential race down to two untraditional candidates, should investors be concerned about what's next for France and the EU? Our affiliates look through the short-term noise to the election's longer-term impact on problems of the French economy, as well as the European Union.


Despite Marine Le Pen advancing to the second round of the French election after receiving 21.4% of the vote, investors seem reassured by the strong showing of the centrist Emmanuel Macron, who took 23.9% in yesterday’s first round. The euro gained on the dollar – pushing above $1.09 for the first time in five months – and against the British pound and Japanese yen as well. Prices on French bonds also rose, lowering yields to just 48bps over those of Germany, the lowest level since January. French stocks – particularly its banks – rallied, with the CAC 40 jumping 4% at open.

Francois Fillon, the conservative former prime minister, has now thrown his support behind Macron, as have other establishment politicians keen to prevent a Le Pen victory. For now, markets seem reassured that the free-market, European-Union loving Macron will triumph May 7.

Below, investment managers Brandywine Global, Martin Currie and Western Asset look through the short- term noise to the longer-term impact of the election on the underlying structural and competitiveness problems of the French economy, as well as the European Union.

 

Thoughts from Brandywine Global:

We have limited optimism toward the euro and core European bonds—a view we did not change heading into the French elections. As long-term investors, we do not have any plans to change our thinking based on the results of the April 23 election. We are only halfway through the European election cycle, and investor sentiment continues to conflict with macroeconomic factors. It will only be after these elections are over that we can let market and economic forces truly go to work, in Europe and around the world.   

Prior to the election, the odds were in favor of a runoff between Marine Le Pen and Emmanuel Macron, and fell within the margin of error. Macron did manage to surprise to the upside by generating enough confidence in his ability to address national security following the April 20 terrorist attack in Paris. Despite the likely odds of a Le Pen runoff, we think markets will return to a risk-off environment until May 7—or beyond if Le Pen actually wins the presidency. Markets will have many uncertainties to sort through from now until round two, including Le Pen’s ability to garner votes from those who initially favored Fillon or whether French voters actually overwhelmingly support the country’s EU membership and will instead vote for Macron. He will face his share of obstacles, as Macron will have to convince voters he has the gravitas to handle national security despite his lack of experience.

Le Pen’s win confirms the deeply entrenched populism outside of Paris and this will be a close race, although we think Macron will ultimately best Le Pen. Her advancement to the second round may be a wake-up call to mobilize more centrist voters in favor of Macron. Leading up to the April 23 election, polling suggested that the French were overwhelming supportive of EU membership and the currency. A pro-EU president could cause the euro to rally, and core European yields should rise. A Macron victory would be a boon to a risk-on environment. We would be comfortable with Macron at the helm given his career in investment banking, and as the Minister of the Economy, Industry, and Digital Affairs in the second Valls government.

 

Thoughts from Martin Currie

 

From Michael Browne, Portfolio Manager:

We have seen investors avoid Europe due to the risk of “Frexit” brought by Le Pen. We have argued this is unlikely, even if she did take power, and yesterday’s result makes it even more unlikely. But even if, as expected, Macron wins in the second round, we will have to wait for the Assembly elections in June to see what sort of government we will face. It seems likely that the machines of the Republican party will fire up again and split France down the middle, leaving no party with a majority – leading to a coalition. We are in for a period of co-habitation the likes of which has never been seen before under either Francois Mitterrand or Jacque Chirac.

This suggests that the ability to pass new radical laws is quite low, so major reforms are unlikely at this point. The markets may not mind this, but it would allow the extremes of French politics to argue exclusion and does not settle the problems that concern the voters of the far left or far right (who comprised 40% of first round voters).

The real sell-off will be in bonds, with spreads between France and Germany narrowing, and the possibility that the ECB can move from a negative deposit rate to flat, or reduce quantitative easing sooner than expected.

This is very bullish for banks. We are also bullish on European equities overall, with this positive result, alongside the strong economic data and the start of a good reporting season, setting the scene for a positive second half of the year.

 

Thoughts from Western Asset Management

From Andrew Belshaw, Head of Investment Management, Europe:

The risk premium built into French bond spreads over the last three months has begun to unwind. Periphery spreads, particularly Italian, have also compressed, having had widened with France in recognition of the threats posed to the future of the Eurozone by the candidacies of Le Pen and Melenchon. The safe haven bid that German Bunds attracted has similarly unwound. France – German spreads have narrowed to +50bps from a high of +80bps a week ago. Italy – German spreads have narrowed to +175bps from a high of +200bps a week ago. In yield terms (10-year), France dropped 10bps and Italy 6bps, while Germany rose 9bps.

Given the relative stability of the polls since February, we have been of the view that Macron and Le Pen would be in the final round with the former as the winner. However, the economic programmes of both are such that, in our view, the underlying structural and competitiveness problems of the French economy will not be adequately addressed by either. Consequently, we believe French spreads should trade in the region of +50 to +60bps against Bunds, not the +20 to +30bps that was prevalent until the fourth quarter of last year.  After today’s move, spreads are now at fair value at best.

The second round is on Sunday May 7 and scope remains for volatility in French assets over the next two weeks. Medium term the focus will shift to the Assembly elections, the first round of which is on 4th June, followed by the second round on 11th June. The fact that Macron and Le Pen both lack the support to form an administration in the Assembly suggests co-habitation may prevent any radical policies being enacted. This reinforces our long-term negative view on French assets.

 

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