French election and fears of Frexit

Jean-Philippe Bry's picture

The market is fretting over a possible Le Pen victory in France’s presidential elections scheduled in April and May 2017.  Markets are nervous and sovereign spreads on French government bonds recently reached a 4-year high (see graph below). So what are the risks?  Should investors be looking at this as an opportunity or an existential risk to not only France but the future of the Eurozone?

French government bond yields less German government bond yields

Source: Bloomberg

A real risk exists that Le Pen could win the French elections, even if her odds are low given the structure of the French election system which will be described below.

The politics of rage have been lingering in France for many years with the same themes that were evident in the U.S. election and the Brexit vote. In fact, the issues are more pronounced and gone on for longer in France than in either the U.S. or the U.K.

If the electoral system in France was “First past the post” as in the U.S. or the U.K., Le Pen would be the outright favourite to win the presidency.

France is different from most western democratic regimes in that elections require two rounds of voting unless a candidate obtains 50% in the first round.  A presidential candidate must win 50% plus one of the votes to be elected.  All presidential elections in France under the fifth republic have required two rounds of voting. All other elections generally require two rounds of voting but a run off can take place with three candidates depending on the first round results with the winner  sometimes winning with  less than 50% of the votes in the second round.

While Le Pen is ahead in the polls and likely to obtain the most votes in the first round, thus ensuring a place in the second, she faces a number of challenges to reach the 50% plus one required to win the presidency.

The first is that she has never polled more than 27% nationally in any election. This is true even for regional elections which have traditionally been a boon for the opposition parties, as they tend to attract the protest vote since they have less significance and are between presidential terms. In the regional elections of 2015, Le Pen’s party failed to win any region, coming closest in Provence-Alpes-C ôtes d’Azur, considered the bastion of the party with 45.2%. 

The fault with this argument is that regional elections tend to have low turn out which is to the benefit of the main stream parties. Presidential elections tend to have high turn out and given the interest and emotion surrounding this election one should expect a very high turn out, which will be to Le Pen’s advantage. 

This election is proving to be a roller coaster as it is marred in scandal, beginning with the center right, the party that is seen as the strongest challenger to Le Pen with a radical reform platform. It’s candidate Francois Fillon is now implicated in a scandal involving his wife and children that has torn the party appart. While Fillon maintains a core base of loyal supporters his poll ratings are plummeting. The scandal plays into the hands of Le Pen who can remind voters of the patronage and corruption at the heart of traditional parties. Even if Le Pen herself faces investigations into fraud and misallocation of finances from Europe,  she can more easily dismiss them as a campaign by the establishment to delegitimize her and her party. 

The left wing is split , leaving only the inexperienced and never elected Emmanuel Macron who is seen as a centrist and reformist.  He has no political party but is now leading in the polls, even if he is considered from the establishment graduating from an Elite state school and having worked as an investment banker at Rothschilds. His strength is his youth and the refreshing air of novelty he brings to the campaign.  No one can say whether his numbers can hold up (especially in a second round, assuming he qualifies) when the gloves are expected to come off with Le Pen considered a formidable debater.

Deciphering emotion over rationality

The underlying issues fuelling Le Pen’s populist movement remain omnipresent and are regularly reinforced.  The Le Pen narrative simply stated is:  

  • Migrants are siphoning resources when they could be going to French nationals.
  • Suburbs are increasingly unrully and often violent as a result of failed immigration policies.
  • Structural unemployment as a result of globalization/technological development.
  • The corrupt establisment with Fillon’s recent issues with the law.

While in some areas like employment and the migrant crisis things have improved. However not enough to shift the balance for those who are dispossessed and fallen out of the system.

Herein lies the problem in evaluating  Le Pen’s chances. Should she manage to get the dispossessed out to vote, her chances would increase significantly.  It is not dissimilar to Trump  who was able to uncover voters that had dropped out of the system. Many of these potential voters do not figure in polling  statistics because they no longer vote.  

Naturally any event, such as a terrorist attack that illicits a strong emotional response, would play into the hands of Le Pen.

What if she wins

Even if Le Pen wins she will not be able to win a majority in the National Assembly scheduled one month after the second presidential round. (Even her own party admits to this reality.)  It means she will not be able to achieve many of her objectives like leaving the Euro. The Euro is inscribed in the French constitution.  A  constitutional amendment requires the approval of three-fifths of the National Assembly and the Senate. Going directly to the people with a referendum also requires the approval of the National Assembly.  There exists an outside possibility of having a referendum with Article 11, once used by President de Gaulle, however this is contested by many consitutional scholars.

Polls suggest that the majority of the French, even within Le Pen voters,  do not support leaving the Euro. It appears that most of her supporters want to give Le Pen a chance to govern rather than give a mandate to leave the Euro, for now.

Investors will remain cautious at least until the outcome is final.  While holding shares in the French index represents limited risk because their international exposures look particularly bright at this time, we feel that holding French government bonds is more risky. We currently hold some French stocks but are absent in French bonds.

A Le Pen win does not mean the end of the Euro. The markets are more likely to worry about that possibility, pricing  French assets lower.  Given the continued improvement in the economy any stock market weakness should prove temporary, especially for large cap French multinationals.  For bond yields that might be a different story. 

Source: Exanne

Disclaimer
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments.

 

 

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