Le Pen, Frexit and the future of the EU

Are markets on the edge of reason?

“The outcome of the Dutch elections saw Europe pass its first political test of 2017. But even as financial markets have caught their breath, the spread between French and German sovereign yields reminds us that the continent’s biggest electoral test is only weeks away.

“Part of the current discount on European equities is clearly attributable to the risk of a Le Pen presidency, although we would argue that the nature of the French political system renders such a victory unlikely. And should Le Pen even succeed in becoming president, her chances of taking radical steps, such as exiting the single currency, seem very low.

“With European equities weighed down by political concerns, we think that investors who look to economic fundamentals will ultimately be rewarded. Positive earnings revisions in the corporate sector, relatively low interest rates and a steady improvement in growth support our view that Europe is in the best economic shape it has seen since the crisis. Now seems a good time to add exposure to attractively priced equities in the region (save the UK).

Assessing the odds of the worst-case scenario

“While a number of commentators are focused on Le Pen’s strong first-round polling, the odds of her succeeding in the run-off, and ultimately becoming president, are significantly lower. In our view, come the second round, the radicalness of Le Pen’s policies will draw unity in opposition – across the left and centre of the political spectrum.

“In addition, it is worth remembering that, in France, it is the government that governs. With few parliamentary seats and no obvious allies, even if Le Pen were to clear the near-insurmountable second-round hurdle, she would almost certainly find herself unable to form a government – or secure sufficient parliamentary support to organise a referendum on Eurozone membership (let alone win it).

“But in a post-Trump, post-Brexit world, outliers deserve special attention. In Chart 1 we thus play devil’s advocate, imagining a scenario in which Le Pen first wins the presidency (30% odds according to recent polls, then secures sufficient parliamentary support to hold a Eurozone membership referendum (unlikely) and then manages to convince half of the French people to vote ‘leave’ (equally unlikely). We arrive at a cumulative probability of Frexit in the single-digit range.

Portfolio positioning

“For investors willing to look beyond the political fog, and prepared to bear the associated near-term volatility, the fundamentals of Europe’s recovery continue to be supportive of risk taking. European equities are trading at a 20% discount relative to US peers4, and international investors still have relatively low exposure, deterred by the political uncertainty. A win for Emmanuel Macron – which is, by far, the most probable outcome – should encourage them to reassess their European equity underweights.”

Samy Chaar, investment strategist at Lombard Odier

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