On April 23, the French head to the polls for the first round of their presidential election. The two leading candidates will then face off in a second round on May 7. Pollsters, bookmakers, the media and most experts expect a defeat of Far-Right National Front candidate Marine Le Pen to either Emmanuel Macron or François Fillon. This has been consistent with our view of likely outcomes, but recent developments have increased the odds of a negative surprise, especially in the context of significant polling estimate errors with the U.S. election and Brexit votes. The lack of unified support behind any of the five candidates - save Le Pen - furthers the potential reality of another populist upset at the polls. The parliamentary elections in June have also increased in importance and added to uncertainty surrounding the future of French politics and policy.
Historically there have been three leading political parties in France with roughly equal representation: 35% for the Left, 35% the Center-Right and 30% on the Far-Right. This allowed the more moderate factions of the Right and Left to form a coalition and block the Far-Right from power in both presidential and parliamentary elections. Currently, the Left and Right parties are internally splintered and bitterly divided. Supporters from the Center-Right are upset that Fillon’s campaign imploded over charges of financial improprieties and nepotism. It is not clear they will shift their votes to Macron, who is endorsed by former Socialist Party PM Manuel Valls and may be unappealing as a typical, well-mannered eurocrat. This fracturing of the Right could end up benefitting Le Pen as polls show Macron voters are less committed and certain than either Fillon or Le Pen supporters.
"We still believe odds favor the eventual victory of Macron over Le Pen in the second round, but it will be much closer than polls indicate."
The division of the Far-Left between Jean-Luc Melenchon and Benoit Hamon could further siphon off votes from the moderate and unexciting Center-Left Macron. Polls show that all of this division is producing a high number of undecided citizens so turnout will be key. As a result, uninspired voters from the Left may just stay home rather than support either Macron or Le Pen. This could lead to a much stronger showing in the first round from Le Pen, which would unsettle markets.
More disturbingly, Melenchon has recently been gaining in the polls which could lead to a four-way race into the second round. If his rising popularity were to result in an agreement for Center-Left candidate Hamon to step aside, it could increase the odds, while still very unlikely, of a Far-Right vs. Far-Left second round. Investors would view this quite negatively as both are strong euro skeptics, likely leading to speculation of France leaving the EU.
Less discussed but potentially more important are the two parliamentary elections on June 11 and 18. Historically, the clear divide between Right and Left has allowed the majority coalition to quickly form a government with fairly predictable policy implications. But the current split has created the potential for four or five political blocks with little in common. This will make forming a governable legislature by either of the eventual presidents a challenge. The resulting gridlock might lead to an institutional crisis with the dissolution of parliament and new elections.
Overall, we still believe the odds favor the eventual victory of Macron over Le Pen in the second round but it will be much closer than the current polls indicate. The probability of Le Pen winning has risen, which would be a negative shock to investors, but the lack of cohesion in the legislative elections is our greatest concern. Gridlock and policy uncertainty might cause the strengthening economic recovery in Europe and France to stall similar to the current situation in the U.S.
The range of potential risks in the financial markets is no easier to predict than the outcome of the French elections. Investors who panicked and sold shares after the Trump election, Brexit or the failed Italian referendum are sporting significant losses. Even when a politician is intent on delivering upon campaign promises, stock prices can behave unexpectedly as the near 20% gain in Mexican equities this year demonstrates. Consequently, the most helpful framework is to consider the degree to which stocks prices already reflect investor anticipation of a particular outcome or high degree of uncertainty. European stocks have risen approximately 7% this year, led by a recovery in industrial and financial stocks and appear to not reflect a high level of concern for the upcoming elections. On the other hand, the high level of political uncertainty has driven European shares back to a near record valuation discount relative to the U.S.
"We believe an initial negative reaction to a Le Pen victory could be followed by a rebound in French and southern European shares."
The risk to the currency from a Le Pen victory and move to abandon the euro also needs to be viewed in the context of significant undervaluation. Clearly, the immediate reaction would be a jump in the U.S. dollar and Japanese yen, but the rise in interest rates from falling French bond prices might cause Le Pen to moderate her stance on leaving Europe. Surveys of the French people indicate 70% remain in favor of keeping the euro so a “populist” president would be supported in not embarking on “Frexit.” As president, Le Pen would also need a solid majority in parliament to leave the EU and such a degree of alignment is highly unlikely.
Following the contrarian behavior of markets after unexpected political outcomes, we believe an initial negative reaction to a Le Pen victory could be followed by a rebound in French and southern European shares. These long suffering economies would benefit from an improvement in competitiveness and more autonomy over fiscal and monetary policy. Italian stocks have moved to the largest valuation discount in over 20 years relative to the rest of Europe and could rally significantly, especially depressed banking shares. On the other hand, German equities and bonds might underperform as previous “safe haven” trades are unwound. Cyclical and financial companies would experience a correction after strong gains in the past year but also would benefit from a lower euro, greater inflation and higher interest rates. A victory by market-friendly Macron or Fillon would likely produce a resumption of the relative gains in European stocks and a rise in the euro. Buying great companies in the face of politically induced panic and uncertainty seems to be working well and we don’t expect to treat the upcoming French election any differently.