QUENTIN LAFOSSE
Portfolio Analyst
Europe Still Deciding: French Presidential Elections, April/May 2017
Executive Summary
ƒƒ The French presidential election is shaping up to be a
four-candidate race between
Emmanuel Macron (centre),
François Fillon (right), Marine
Le Pen (far-right), and JeanLuc Mélenchon (far-left)—all
currently within 4 to 5 points
of each other.
ƒƒ Round one will be held on
Sunday, April 23, and (if no
candidate gains half the vote)
the final two-candidate run-off
election will be on May 7.
ƒƒ This paper details the broad
characteristics of these four
prospective leaders, including
their views on Europe and main
economic policies.
ƒƒ The consensus expectations
are for Macron and Le Pen to
pass through to the second
round, where a Macron victory
would be expected.
ƒƒ Fillon’s recent recovery in the
polls gives him momentum
and his potential presence
in the second round, while
surprising, should not be disregarded.
ƒƒ In the unlikely event of a Le Pen
or Mélenchon win we expect
this would have significant
market implications in the
short term with a sharp rise
in eurozone risk premia but
consequently provide attractive opportunities for astute
investors.
Introduction
With just under a week to go, the first round of the French presidential elections is upon us, and some worry
it will follow in the footsteps of the political tsunamis of 2016. Until recently seemingly a two-horse race, the
polls now suggest convergence on an almost-equal probability for each of the four main candidates from
across the political spectrum: far and centre, left and right (Exhibit 1).
In this short note, we freshen our views expressed in Europe Decides: Elections, 2017, and reaffirm our belief
that while turbulent, the next few weeks will offer opportunities for a value manager such as Western Asset.
Given the magnitude of shock that a Marine Le Pen victory would entail, however, we explore the constraints
she would face in attempting to challenge the whole Euro project.
What’s coming? A quick reminder.
On Sunday April 23, the French people go to the polls for the first round of a two-round election to choose their
President of the Republic. The first round will whittle the 11 registered candidates down to a final two, who will
fight it out two weeks later on May 7. While it is a very powerful position, not unlike that of the US presidency,
the winner will be reliant on the support of the French Parliament for many key issues, most notably any significant change in France’s relationship with the European Union (EU). Under the Constitution, only the Prime
Minister (PM), or a majority of either chamber of the Parliament, can call a Referendum on EU membership, as
we will discuss later. None of the most extreme candidates (far-right Le Pen or far-left Jean-Luc Mélenchon)
look likely to have enough support in the Lower House of Representatives, to appoint a PM from their party.
This adds to the uncertainty, however, as a Parliamentary general election follows on quite quickly, again in a
two-round format, on June 11 and June 18.
What’s happened in the past month?
Over the past few weeks, opinion polls have been incredibly dynamic highlighting the fact that this election
outcome is undoubtedly one of the most unpredictable in recent French history. Having seemed to be a
straight two-horse race between Le Pen and Emmanuel Macron, the Centre candidate, Francois Fillon, the
Republicans’ candidate, mounted a brave comeback in April. Then, Mélenchon surged forward to formally
enter the “final four,” almost catching Fillon, and fueling significant uncertainty ahead of the first round. At the
time of writing, we have the top four candidates (Le Pen, Macron, Fillon, Mélenchon) all within 4 to 5 points
of each other, each with roughly 18% to 23% of the vote, albeit constantly evolving (Exhibit 2). Furthermore,
turnout is expected to be relatively low at around 70%. A low turnout tends to benefit non-mainstream
candidates. Historically, turnout for French elections has been around 80%-85% except in 2002 (72%) when
Jean-Marie Le Pen (Marine’s father) made it to the second round.
What does this mean for markets?
As we explained in Europe Decides: Elections, 2017, each of the main four prospects would likely impact French
asset prices. In some cases, there would be a broader implication for EU-wide assets, including Italian and
peripheral bonds, as well as the euro currency. Clearly the change in the balance, from two clear final-round
candidates, to the prospect of any two from four, has increased the likelihood of more market-unfriendly
outcomes, including a Mélenchon–Le Pen second round. In Exhibit 1, we detail the broad characteristics of
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Europe Still Deciding: French Presidential Elections, April/May 2017
Exhibit 1
The Candidates
Key
Candidates
Emmanuel Macron
(“En Marche”/ Centre)
Francois Fillon
(Republicans/Right)
Increased European cooperation
Favors a “Europe of nations”
Stronger eurozone
More fiscal integration for a stronger
eurozone
Europe
Stronger role for sovereign states
with more representation in
Brussels
Supply-side economic policies
Supply-side economic policies
€50 billion public investment plan
over five years
Reduce public spending by
€100 billion over five years
€60 billion in planned public
Main
Economic spending cuts over five years
Policies Simplify pension system (no plan
to change retirement age)
Jean-Luc Mélenchon
(”France Insoumise”/Far Left)
Renegotiate European treaties during
the first few months in office
Renegotiate with Brussels and strike a
“new deal” for France within EU
Referendum on EU membership
following negotiations
Only hold a EU membership
referendum if negotiations fail
Regain border controls
Primacy of national law over EU
law
Protectionist economic measures
(3% tax on imports, 10% tax on
hiring foreign workers)
Regain control of currency and
monetary policy
Increase retirement age to 65
Greater labor-law flexibility
(repeal “35-hour week”)
Reduction in tax and levies on
households, cut corporate tax for
small and medium-sized
enterprises (SMEs)
Corporate tax cuts (25% down
from 33%)
Greater labor market flexibility
Marine Le Pen
(Front National/Far Right)
Corporate tax cuts (25% down
from 33%)
Reduce retirement age to 60 and
increase retirement benefits
Demand-side economic policies
Significant increase in public spending
financed by higher mandatory levies
and a larger deficit
Material increase of the minimum
wage
Proposes eurozone sovereign debt
restructuring
Reduce the workweek to 32 hours
Reduce retirement age to 60
Source: Western Asset, based on candidates’ programs
these four prospects. They occupy the full spectrum of economic, social and political policies as one would
expect. But in the case of the relationship with Europe, while Mélenchon emphasizes the need to strike a new
deal for France in the EU, only Le Pen really threatens a significant change, and as we elaborate on Exhibit 5,
would be restrained by the likely outcome of June’s Parliamentary election. It is also important to note that
with the UK continuing its plan to leave the EU by triggering Article 50, all four candidates will be engaged
in “renegotiating” France’s role in the new post-Brexit Europe.
Exhibit 2
Evolution of the Polls (average of latest 3 polls)
Percentage of First Round Votes
30
25
Le Pen
Macron
Fillon
20
Mélenchon
15
Hamon
10
5
0
30 Jan 17 10 Feb 17 20 Feb 17 02 Mar 17 12 Mar 17 21 Mar 17 31 Mar 17 09 Apr 17 17 Apr 17
Source: Opinion polls, Wikipedia. As of 17 Apr 17
Western Asset
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April 2017
Europe Still Deciding: French Presidential Elections, April/May 2017
Exhibit 3
France: Government Bond Spreads
100
Exhibit 4
Difference Between Euro/Yen Puts vs Euro/Yen Calls, 25 Delta, % Vol
10-Year Spread to Germany
Percentage Points
Spread (bps)
80
60
40
20
0
Mar 16
Jun 16
Sep 16
Source: Bloomberg, Western Asset. As of 31 Mar 17
Dec 16
Mar 17
1
0
-1
-2
-3
-4
-5
-6
-7
-8
Brexit
Greece
Draghi “whatever it takes”
French
Election
Sep 09 Jun 10 Mar 11 Dec 11 Sep 12 Jun 13 Mar 14 Dec 14 Sep 15 Jun 16 Mar 17
Source: Bloomberg. As of 17 Apr 17
How have markets behaved?
While it’s impossible to extract the other influences on markets, including events on the geopolitical stage,
it’s likely that the uncertainty of the French elections has at least enhanced the trends we saw in place in
March. French bond spreads relative to Germany have widened to their post-2012 wides (Exhibit 3), but there
are very few signs of true stress in cash bond markets.
Perhaps the clearest evidence of market stress comes from the currency markets. Recent data released
by the Bank of Japan show Japanese investors’ net sale of ¥1.5 trillion (€13 billion) of French Bonds during
February, the largest monthly sale in five years. It is thought, however, that they continue to hold significant
exposures to France and other European bonds, although sales may have continued into March. This may
explain the fact that the currency options markets1 are signaling that the cost of insuring euro exposures
has been increasing sharply, as witnessed by the growing preference for euro puts relative to equivalentdelta euro calls. As Exhibit 4 shows, this preference, in terms of the implied volatilities charged for options
on euro/yen, is back at levels seen during the height of the Euro Crisis in 2012, when European Central Bank
(ECB) President Draghi promised “whatever it takes.” 2
However, when looking at the broader influences on peripheral bonds, the response has been somewhat
muted as we expected.
What does all this mean for client portfolios, and have we changed anything?
We have had a negative view of French assets for a number of years from a fundamental economic point of
view. The structural challenges to the French economy and the lack of desire to confront them, particularly
Currency Options to buy/sell a currency versus another, are described as a call (to buy) the yen versus simultaneously
selling (put) the euro, as a predetermined level (the strike price) say 115 yen to the euro. Therefore a euro call/yen put
allows the owner of the option to buy euros and sell yen. The price of this option is determined by a number of factors
including the proximity of the current exchange rate to the strike price, relative interest rates, the maturity of the option,
and finally, the implied volatility. The higher the vol, the more the option will cost. The exposure obtained through the
option will be determined by the delta, the relative movement in the option price for a given move in the underlying
(euro/yen exchange rate).
2
By taking two options of equivalent delta, one a euro call/yen put and the exact opposite, a euro put/ yen call, both with
a 0.25 delta, we can take the implied volatility priced for each as a reflection of the strength of preference the market
has for Euro puts versus calls. That is, a reflection of which direction (up or down) the market fears most for the euro/yen
exchange rate. Normally the implied vols will be similar for a given delta. But from time to time, as we show in the chart,
the implied vols (and therefore the cost of the options) will be significantly greater for euro puts versus euro calls. Currently
implied vols on euro puts (24%) are greater than calls (17.5%) by over 6% implied volatilities for a 1-month maturity taking
us past the French election.
1
Western Asset
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April 2017
Europe Still Deciding: French Presidential Elections, April/May 2017
under the presidency of Francois Hollande, have led us to maintain a large underweight to French bonds in
dedicated European portfolios. Post the election of Donald Trump in the US, we thought French risk premiums had to rise further, believing the election uncertainty in an increasingly populist world was not priced
in. We will continue to maintain this position until we believe spreads more adequately compensate for the
risks entailed. Depending on the evolution of opinion polls and the first round of the presidential election,
that would be somewhere north of 100 basis points against Germany on a spread basis.
We continue to expect the ECB to support EU assets, alongside the robust growth trends we see in Europe.
Provided they maintain their reform agenda, we feel Italian bonds already compensate investors for the
heightened political uncertainty in France. Our key ballast against an increase in volatility remains a long US
duration stance, with a bias towards 30-year US maturities. In the absence of a Le Pen or Mélenchon win on
May 7, we expect German government bonds to underperform as eurozone political uncertainty wanes. In
dedicated European portfolios, therefore, we have moved to a short duration position in core European bonds.
Finally, with the euro currently trading at the lower end of the range versus the US dollar (that it has held for
two years), we feel political risk ahead of the upcoming elections is now likely factored into the euro’s valuation, and we have moved to a more neutral/modest long position in European currencies versus the US dollar.
Exhibit 5
How Could Le Pen Force a Referendum on EU Membership?
One area of concern for the markets is the way this election could potentially shape the future of the EU. As France’s EU membership is
written in the French constitution, a constitutional change (modification) is therefore necessary to modify France’s status in the union.
Although a legally complex process subject to interpretation, this could be achieved in several ways including a constitutional
referendum proposed by the government (PM) and approved by a majority of both houses of Parliament. Alternatively, the
constitution could be amended without the need for a referendum if the modification proposal is approved by 3/5 of the Congress
(convened lower and upper house). While other scenarios could potentially be considered, without a majority in Parliament,
amending the constitution would prove to be a very long, drawn-out process with many hurdles on the way. In addition, studies
conducted after the UK's decision to leave the EU (eg., Ifop poll, July 2016) show that among the French population, the EU
membership and the Euro currency remain popular.
Source: Western Asset, Wikipedia
Conclusion
The risks have clearly broadened, with four prospective candidates increasing the number of market-unfriendly
scenarios. The consensus expectations are that the first round will see Macron and Le Pen pass through to
the second round, and that a Macron victory should be expected. Fillon’s presence in the second round
would be a surprise but cannot be fully disregarded. In the unlikely case where either Le Pen or Mélenchon
becomes president, significant uncertainty will linger. As we’ve discussed, however, it will be very difficult
for either to follow through with promised renegotiations or an EU referendum. The prospect of a sweeping
success for Le Pen’s party at the general elections, while of low probability, would be of tectonic magnitude,
entertaining perhaps the full breakup of the Euro project, though it would take markets quite some time to
fully price in such an outcome. As a result, we anticipate the elections will provide attractive opportunities
for astute investors, but remain vigilant that these days extreme events can be more likely than expected.
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Western Asset
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April 2017