Which candidates are most likely to make the second round?
Jean Pierre Petit: At the moment, the likeliest prospect is a second-round face-off between Marine Le Pen and Emmanuel Macron or François Fillon.
Antoine Lesné: We should not forget that the polls had Hilary Clinton winning after every televised debate. That said, in elections by direct universal suffrage, polling results should be closer to the actual final result. At the moment, the gaps between candidates are wider than the margin of error. Nevertheless, the risk of a surprise will still be there until the evening of 23 April.
Figure 1: Voting Intentions for the 1st Round of French Presidential Elections (23 April 2017) and Yield Spread of the French 10-year OAT Over the German 10-year Bund
Of all the candidates, who would be best received by the markets?
JPP: For his European vision, Emmanuel Macron is undoubtedly the best placed. For his potential for structural reforms, François Fillon looks the most “attractive”.
AL: But each candidate has a different vision for Europe’s future, ranging from Emmanuel Macron’s hopes for a federal Europe to François Fillon’s proposals for greater integration through an inter-governmental process. Both agree on the need to bring down the deficit and improve fiscal policy, but disagree on the time-frame and methods they would use. As for the markets, they would welcome a victory by either Emmanuel Macron or François Fillon, which could open the way for shares in French companies to converge toward their German equivalents. More obviously, we could expect a slight narrowing of OAT spreads over German bonds. Figure 1 shows how spreads have tended to shrink whenever Marine Le Pen’s poll lead weakens. However, the potential for any narrowing of these spreads remains limited because of the national debt and the potential for its reform.
Could Marine Le Pen win?
JPP: We can’t rule anything out. Political scientists claim that she cannot expect to pick-up many second-choice votes in the second round and that the Front National often hits a glass ceiling, as we saw for instance at the last regional elections. This argument is not totally convincing, though. Many things could yet happen between now and 23 April that would favour Le Pen. A new wave of terror attacks, fresh tensions in the suburbs, further scandals highlighting the corruption of the political elites, etc. Don’t forget that Marine Le Pen has one unarguable trump card over the other candidates: she has never exercised effective power at the state level. We should also stress that the presidential election is a one-off and we cannot rule out a slump in turn-out (which would help Le Pen) in the second round, particularly in the case of a duel with Benoît Hamon.
Would the election of Marine Le Pen automatically mean exit from the eurozone?
JPP: No, since any attempt by Marine Le Pen to hold a referendum would seem to require a parliamentary majority. The parliamentary elections are coming up in June 2017. But the Front National generally polls less strongly in these elections, compared to the presidentials, and in general the two-round majority electoral system used is bad news for a party with no allies. Finally, we should point out that the latest opinion polls on the issue (remaining in the EU or in the eurozone) show public opinion is still fairly heavily in favour of the status quo.
AL: Currency markets are bearish on the euro but are not pricing in any potential French exit (see Figure 2). Risk reversal options are used as a proxy for trader sentiment on the euro-dollar exchange rate. The fact that it is negative shows uncertainty and deep pessimism about the euro’s future. However, it is not as high as during the eurozone crisis of 2011–2012. This confirms how difficult it would be for President Le Pen to push through a euro exit, at least in the opinion of market dealers.
Figure 2: EUR/USD 3-month options — fall-off in bearish sentiment since 22 February 2017
How can we hedge the main risks identified?
JPP: In the bond segment, the German market is the natural protection vehicle. On the foreign exchanges, it’s the Swiss franc.
In equities, things are more complicated. Since the mid-1990s when the arrival of single currency began to loom, sector dispersion has proved much more effective than geographical dispersion in the performance of European shares. Country dispersion only comes to the fore again when, precisely, political risks rise and sovereign spreads widen, as happened in 2010–2012 during the European sovereign debt crisis. But we need to remember that CAC 40 firms make more than 70% of their revenue outside France (nearly 40% outside the eurozone). It would mainly be French domestic stocks that would come under pressure, and financials which would be hit simultaneously by their exposure to French sovereign debt, tougher borrowing terms on the markets and, probably, capital flight. The same goes for the peripheral markets vulnerable to contagion, particularly Italy and Spain, whose stock markets are heavily weighted toward banks. On the other hand, French stocks with a heavy international component (which benefit from a falling euro) and low CDSs would be relative winners. A parallel long position in the Dax 30 would be justifiable as a hedge. The Dax heavily outperformed during the European crisis of 2010–2012.
AL: A prudent approach favouring strategies that mix quality and stable dividends or low volatility and quality in euros might be advisable in light of these risks. If Marine Le Pen wins, spreads on OATs over their German equivalents could widen sharply, toward 1.5–1.6%, or even reach the levels of mid-November 2011 when the eurozone crisis was in full swing amid worries over Irish debt and the yield spread topped 1.9%. A more general diversification of the portfolio outside the euro could be a way to limit the negative impact of a collapse of the zone. The Swiss franc and yen could act as safe-haven assets. US equities should also outperform European shares in such a scenario.
Would an exit by France spell the end of the EU or the eurozone?
JPP: An exit by France from the European Union would significantly increase the likelihood of the end of the euro and possibly the end of the EU, given its economic and political clout within the area: it generates 17% of EU GDP and 20% of the eurozone’s, and is a major political and military power.
AL: In a scenario currently seen as so unlikely, the markets would undoubtedly react violently. Risky assets could fall sharply. German bonds might not offer a safe haven. As for OATs, the risk of default would become non-negligible if the franc had to be devalued. Assets such as gold, therefore, look like a safer haven to await developments until the new direction of such a radical change becomes clear.
What can we learn from European ETF investor flows?
AL: Flows toward euro sovereign fixed income ETFs remain negative overall year to date (-$770mn). A more detailed analysis shows, however, that there is a rotation out of the European periphery countries and out of very short maturities (1–3 years). We have seen positive flows into euro inflation-linked exposures, as well as mid-range maturities (3–5 and 5–7 years). Investors are positioning themselves to short Italian or German debt in order to express their views on fixed income risk or Italy. Based on the information collected by the research teams of State Street Global Markets, institutional investors are still underweight eurozone sovereign debt but flows have recently taken a more positive turn. Also, the recent widening of OAT spreads seems to have revived the markets’ appetite for French debt. Portfolios are slightly overweight and capital has been flowing into France in recent weeks. These are signs that ultimately investors feel they have little to fear from the election results. Complacency or sang-froid? In late April we can start to draw conclusions.
Figure 3: 10-Year Sovereign Bond Yield Spread
Jean Pierre Petit is head of Cahiers Verts de l’Economie and Antoine Lesné is head of SPDR ETF Strategy & Research EMEA