How the French Elections May Affect the Financial Markets

April 20, 2017 09:03

On 18 March, the Constitutional Council of France announced that 11 candidates had fulfilled the conditions to participate in the first round of presidential elections, due to be held on 23 April.

The Constitutional Council noted that the first round candidates will be François Fillon (The Republicans); Benoît Hamon (Socialist Party); Emmanuel Macron (En Marche!); Nicolas Dupont-Aignan (France Arise); Jean-Luc Mélenchon (Left Party); Nathalie; Arthaud (Workers' Struggle); Marine Le Pen (National Front); François Asselineau (Popular Republican Union); Philippe Poutou (New Anticapitalist Party); Jean Lassalle (Résistons!) and Jacques Cheminade (Solidarity and Progress).

Among all of these candidates the focus is on Emmanuel Macron, Marine Le Pen and François Fillon.

French presidential elections are the focus of the global financial markets. According to public opinion polls, Marine Le Pen, leader of the right-wing National Front, has a good chance of entering the second round, along with centre candidate - Emmanuel Macron. But what if Le Pen emerges as the victor? What will this mean for the French economy and the fate of the Euro?

Preliminary polling data, collected on March 29, showed Fillon/Le Pen at 60/40 respectively, as opposed to 58/42 prior to that date. In the first round of polling, Le Pen/Macron/Fillon were 25/25/20, as opposed to 26/24/20 earlier. This shows some lost ground for Le Pen. Source: Forexlive.com

My personal opinion is that that no one will win the election in the first round. There is a chance that Marine Le Pen might win the first round, but in French presidential elections, if no candidate receives more than 50 per cent of the vote in the first round, the two candidates with the highest share of the vote proceed to a second round of voting.

Current data shows that Marine Le Pen and Emmanuel Macron are leading the race. However, research has also predicted that Macron would probably beat Le Pen if a second round were to take place on 7 May – polls for which are currently around 61 per cent (Macron) to 39 per cent (Le Pen).

What may be a surprise is the popularity of the far left candidate Jean-Luc Mélenchon, who's had a huge surge in popularity, going from around 10% in late-February to 18% at last count on Bloomberg's Composite poll. This puts Mélenchon pretty much on par with Republican François Fillon's 18.5%. This late surge from Mélenchon, as well as the resilience of the defamed right-winger Fillon, has definitely broadened out the competition.

The Absence of a Structured Budget Framework

What has been very impressive during this French presidential election is the way in which most of the candidates, particularly François Fillon and Emmanuel Macron, have very carefully presented the budgetary framework for the next five years.

They must have learned their lesson from François Hollande, who's overly optimistic economic forecasts presented during the 2012 campaign showed a total lack of reality, having, in my opinion, catastrophic economic consequences. As part of his program, the current president was expected to produce a 2% growth in GDP in 2014, but he actually only provided a 0.9% rise between 2014 and 2016.

In terms of the public deficit, the goal was that by 2017 it should have been lowered to 0%, but, according to official forecasts it should be around 2.7%. As a result of the poor understanding of the economic situation, Francois Hollande has begun to implement an inadequate economic policy before it was forced to enact a large tax increase under pressure from the European Commission.

The Economic Impact From Eurozone Exit Is Hard To Measure

For economists, the main problem is the fact that it is impossible to measure the economic effect of the National Front's program. Indeed, the cost of exit cannot be estimated by current econometric models because such a "black swan" event has never happened in modern history. This is not Brexit, this could be much more than that.

However, what is certain is that an exit from the Eurozone might lead to a renomination of the national debt in the new franc. This question is not so much related to the public debt, but rather how the private foreign debt of households and enterprises, which reaches almost 150% of GDP, will be handled, (in other words it is more than public debt).

It is evident that foreign creditors will not easily accept a "haircut" for a compensation of worthless money, which should cause many legal appeals to international legal systems and further blocking of capital flow into the country.

Le Pen's plans to call an EU referendum upon her victory, which could cause a panic in French based banks as there could be a movement en-masse by the public to withdraw their Euros, and this may cause systemic problems in the French banking system.

The Impact on Financial Markets

This was not an issue with Brexit, as the GBP would remain as the currency regardless of result. However, in the case of 'Frexit', it would mean moving from the EUR to a new currency, which then creates further uncertainty. I believe that the impact of a Le Pen win on the Euro would be huge.

Although the probability of a Le Pen victory is far from certain, markets are not taking any chances. No one thought that Brexit would happen, or that Trump would win… Look what happened there!

In the event of a Le Pen victory, the general response from bond markets is likely to be a spike in French government bond yields to reflect fears of a devaluation. German bunds might rise in value after a Le Pen win, as capital flight to safety and the Euro supports safe-haven flows.

french bond bloomberg.jpg

Source: Bloomberg

French bond yields could spike because of the falling value of French bonds, following a Le Pen victory. Have in mind that yield is a calculation of the gross return that a bondholder can expect and thus includes both the coupon or interest repayments and the principal which is repaid at the end of the term.

Investors who pay less than the original value of the bond – for example, 75 euros instead of the original 80 – will gain an extra 5 euros at the end of the term when the principal is repaid. Add this to the repayments which remain the same and the total return increases, thus increasing the yield.

This should explain why the yield rises when the bond price falls.

For traders who might like to trade the French elections and potential 'Frexit', I believe that EUR/USD and EUR/CHF could be the best pairs to trade. If Le Pen wins, the combination of a weak Euro and Swiss Franc (CHF), which is considered widely as a safe-haven asset, might spur huge volatility in Forex markets.

EURUSD.jpg

A correlation between EUR/USD and EUR/CHF is high, it means the pairs tend to move in a similar direction.

Watch the Final Pre-Vote Poll

The last official poll for the first round will be published on 21 April, as polls are prohibited from being published on the day before the election. Historically, last polls have shown a maximum margin of error of 3.9% from the final result. There is rarely a surprise result from the 21 April poll.

This April 21 poll may cause volatility in the markets. If you plan to trade the election we strongly suggest using our unique Volatility Protection tool.

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The Conclusion

To me, it looks pretty binary: Le Pen or not Le Pen.

If she is elected, the EU leadership will go into a tailspin and the Euro might tank, at least in the short-term. If she loses, then it will be pretty much business as usual. I would expect a short rally then the Euro will continue to make lower highs and maybe a new low.

Longer term, a win for Le Pen would mean a soft landing for the EU. It's going to come apart one way or another. A slap in the face now would force the leadership to reign in some of their ambitions. A loss for Le Pen will mean they will be emboldened in their rhetoric and when the wheels do fall off they will be going 100mph. Not nice.

A Macron or Fillon victory should ensure stability of the Eurozone and further focus will be on making the Eurozone strong again. What if polls are wrong again as they were for Brexit, or Trump? A Fillon return could see the Euro rally in anticipation of a Macron/Fillon second round.

I personally don't think any French politician has the answer to the country's troubles. But one thing is for sure, this is a watershed election!

Cheers and safe trading,

Nenad