If there's one thing markets have had to come to terms with in recent years, it’s that assumption breeds complacency.
Such is the case with the upcoming elections in France: investors should have hawk eyes focused eyes on The Republic.
With the yield spread between French and German 10-year government bonds touching their highest level in almost three years, the market is clearly wary of the economic implications of a Marine Le Pen presidency.
As Emmanuel Macron and Francois Fillon jostle with Le Pen for first place in the polls, the risk of a Front National victory in the presidential race is, in our view, low and yet simultaneously very real.
What if?: The prospects of a President Le Pen
Riding on the wave of anti-EU, protectionist sentiment, the possibility of Le Pen making it to the Élysée has started to put markets on edge. With the party’s key policies including taking France out of the euro and holding a referendum on EU membership, a Front National win could threaten the survival of the European project in the long term, while in the short term, tipping the region’s recovery off its axis.
Despite strong far-right support across the country, Le Pen remains at the mercy of a presidential run-off that she has very little chance of winning. We believe she will ultimately be weighed down by the radical nature of her policies, forcing all opposition to unite against her.
Meanwhile, as a nation of savers, the French people are unlikely to warm to the idea of converting their currency from euros to francs, and therefore putting their hard-fought economic recovery at risk.
Economic recovery: Lost in politics
The febrile political backdrop against which the world now finds itself has cast a shadow over otherwise upbeat economic developments in the region. The Eurozone has started 2017 in the best economic shape it has seen in almost a decade, with most new data pointing to a steady recovery. Against this backdrop, bond spreads should be tightening, but they are instead widening as political noise appears to be drowning out what should be music to the ears of investors.
While a Front National win is not our base scenario, investors might do well to think the unthinkable. In the case of a Le Pen victory, French assets would certainly be sold by international investors as the uncertainties surrounding the implementation the party’s policies – particularly with regards to the redenomination of French euro assets into French franc assets – would prove hazardous.
It is worth noting that a dual currency system (franc/euro) has never worked in the past. The fundamentals of the new franc and the euro would not be considered equal. What is perceived as the stronger of the two currencies (the euro) will be hoarded, while its weaker counterpart (the franc) will be spent and lose value, making it difficult for the Bank of France to maintain any kind of peg.
Brexit: The unlikely deterrent
A French exit from the euro is likely to force investors to increase risk premiums on the euro currency and euro assets as a whole. Meanwhile, a euro without France would surely bring the future of the single currency into question.
Similarly, any referendum on France’s membership would trigger, for the Union, an existential crisis of a magnitude far greater than Brexit. That said, we believe the very fact that Brexit happened makes Frexit less likely. The administrative chaos, the legal conundra, and the social fault-lines uncovered by the UK’s decision to leave the EU could prove a deterrent to other member states. But ultimately, we do not believe it will come to this – the nature of France’s electoral system makes a Le Pen victory unlikely.
Reflecting electoral uncertainty in portfolios
European assets are currently priced to reflect the risks of a busy political year, and benign election results could remove much of Europe’s valuation discount. Given a constructive macroeconomic environment and positive earnings dynamics, we see strong buy opportunities emerging and have started to reduce our underweight in European equities.
We think it is sensible to keep the overall level of risk in portfolios unchanged at slightly overweight, and have also introduced some hedges in preparation for volatility ahead of the elections that could shape the future of the euro. We believe the Swiss franc is an interesting way to hedge European political risk. In our view, it is a more natural “safe haven” investment than gold or US treasuries if investors are concerned about the single currency.
Samy Chaar is chief economist, and Stéphane Monier is chief investment officer at Lombard Odier.