April 21, 2017

Alors on vote

by Fathom Consulting

With the first round of the French presidential election becoming a four-horse race, markets are right to worry about a Marine Le Pen — Jean-Luc Mélenchon runoff on 7 May. Indeed, momentum behind Mr Mélenchon has seen him become the most credible candidate on the left, triggering heightened uncertainty in financial markets. In our view, French and peripheral yield spreads remain too low, underpricing the risk of the next president of France being a eurosceptic.

As political events in Europe unfold, our newly launched section on Thomson Reuters Chartbook, called “European elections”, will provide a useful tool for those who wish to monitor related financial and macro-economic variables. The Chartbook features live charts, allowing users to stay up to date with the latest developments with minimal effort.

This Sunday, voters will decide on which two candidates for the French presidency will make it through to the second and definitive round of voting on 7 May. Currently, four candidates are vying for the position; Mr Macron, Mr Fillon, Mme Le Pen and Mr Mélenchon. In light of the tragic events in Paris last night, the majority of candidates have agreed to suspend their campaign ahead of Sunday’s vote.

While the central scenario in our latest Global Economic and Markets Outlook assumes that either Mr Macron or Mr Fillon will become the next president of France, the narrowing of polls in recent weeks suggests that a showdown between the far-left (Mr Mélenchon) and far-right (Mme Le Pen) is a real possibility.

As our first chart highlights, eccentric left-wing candidate Mr Mélenchon has eaten into Benoît Hamon’s voting base. This “Mélenchon momentum” has turned the contest for the next occupant of the Élysée Palace into a four-horse race, with the spread between candidates surprisingly close at four percentage points. Now within the margin of error, this narrowing in polls makes it increasingly difficult to say with any confidence which two of the four candidates will win the first round.

Heightened uncertainty in the run up to May 7th

In a Newsletter sent to clients last month, we argued that in the run up to the French presidential election financial market uncertainty would rise. Since then, as we predicted, both the VSTOXX Volatility Index and the CAC 40 Volatility Index, which measure volatility in the EURO STOXX 50 equity index and the French CAC 40 Index respectively, have spiked. This has coincided with the rise of the tele-debate favourite Jean-Luc Mélenchon in the polls. Euro volatility against the yen, the US dollar and sterling, as measured by the three-month implied volatility, has also spiked.

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Sovereign spreads are currently too narrow

In the dark world of our risk scenario, described in detail in our Global Economic and Markets Outlook for 2017 Q1, Marine Le Pen or Jean-Luc Mélenchon win the French presidential election, Five-Star become the largest single party in Italy, and AfD do well in Germany (not necessarily in that order). Those political events persuade markets to reconsider the value of the ECB ‘put’ option, the promise implied by Draghi’s “whatever it takes” speech that the ECB will step in and buy peripheral sovereign debt if yields on that debt threaten to rise to unsustainable levels.

That promise has held spreads down since 2012, and the value of the ‘put’ option it delivers to holders of peripheral sovereign debt in Europe has been colossal. But if the very existence of the ECB is under threat due to the election of eurosceptic leaders, then there is a risk that the ‘put’ option will be removed. Markets will reprice peripheral sovereign debt, and all the peripheral economies will spiral towards sovereign default. That will prompt a flare-up of the latent euro area banking crisis, and the process of unravelling of the Economic and Monetary Union (EMU) and, by extension, the EU, will have begun.

We assign a not insignificant 30% probability to our risk scenario materialising. If in that world sovereign bond spreads spike to levels last seen during the height of the 2011 euro area crisis or higher, as our forecast assumes, then at present French and peripheral bonds are overvalued. Indeed, with a weight of 30%, spreads should be roughly one third of the way between where they are in our latest central and risk scenarios. They remain some way below that.

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Alternatively, in the event of a non-populist French president winning the election, spreads between peripheral and German bonds will narrow and equities will rally. Under this scenario, despite a short-term appreciation of the euro, we believe that the monetary policy divergence between the ECB and the US Federal Reserve will see the euro depreciate throughout the second half of this year, driving the common currency to parity against the US dollar by 2018 Q1. In the event of a Mme Le Pen or Mr Mélenchon win, we believe that the euro would depreciate sharply.

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