Handicapping the French election

 
In our meetings, most investors seem to be treating the French election as a simple binary event: will Marine Le Pen win the French presidency or not? This may be because recent political events—the Brexit referendum, the US presidential election—were extreme binary events; only one of two possible outcomes was ever going to occur. However, when looking at the French election, things are more complicated, with many possible combinations of events wreaking potential havoc.
The first source of uncertainty is the implosion of the centre-right. The anger on the right is enormous as François Fillon, through sheer venality, seems to have managed to lose an unlosable election. From our conversations, we gather that the anger isn’t so much that he gave his wife a bogus parliamentary job; that just showed he was “part of the system” (the only surprise was that the job went to his wife. Most delegates choose to put their mistresses on the payroll). Much worse, he had EUR 13,000 worth of suits paid for by a lawyer of Lebanese origin who made his career trafficking French influence across Africa. For most right-leaning voters, this revelation was the straw that broke the camel’s back. How could anyone vote for a politician so willing to sell himself out, and for such a cheap price to boot? This raises the question who center-right voters will cast their ballots for now.
Anyone wishing for stability on financial markets will of course be hoping that Fillon voters will naturally gravitate to the centrist Emmanuel Macron. But this is not an obvious leap, especially now that Macron has been endorsed by the former Socialist Party prime minister Manuel Valls, which makes it easy for opponents to paint Macron as a stooge of outgoing president Francois Hollande.
More importantly, culturally speaking a lot of centre-right voters are closer to Le Pen than to Macron, who—let’s face it—is the ultimate “Davos Man”. This much was obvious at the Trocadero rally Fillon organised to galvanise his supporters following the first revelations of scandal. Every time the names of Macron, or of the left-wingers Benoit Hamon and Jean-Luc Melenchon were pronounced, loud boos could be heard across the crowd. But the mention of Le Pen’s name was repeatedly met with a shuffling of feet.
In short, the implosion of Fillon’s candidacy increases the odds that Le Pen will make a much stronger showing in the first round of the presidential election than the opinion polls currently suggest. Of course, this doesn’t mean that she will rally enough votes to win in the second round. But at the very least, a strong score by Le Pen in the first round will have the potential to freak markets out in the two-week period between the first and second rounds of voting. Many investors will likely conclude that if the polls were so wrong in the first round (and for Brexit, and for Trump), why should they be trusted in the second round?
The second source of uncertainty is the implosion of the Socialist Party. Hamon’s poll numbers continue to slip, and every day sees Socialist dignitaries abandon ship to join the Macron campaign. Those not joining Macron, like former education minister Vincent Peillon, are now calling on Hamon and Melenchon to bury the differences between the Judean People’s Front and the Popular Front of Judea, and put up just one candidate on the left. Such a combined ticket would have a legitimate shot at making the second round. That could trigger panic among investors, because it could leave voters with a choice between Le Pen on the anti-EU far-right and Melenchon on the anti-EU far-left. For now, this scenario seems less likely than a much better first round result for Le Pen, but the possible consequences of such a development are deeply worrying.
The third big source of uncertainty, as Charles Gave has described, is the two-round parliamentary election due to take place on June 11 and June 18. Even if the far-left versus far-right presidential election scenario sketched above fails to materialise, the real challenge confronting France may only be revealed by the legislative elections. Simply put, throughout the Fifth Republic, parliament has been fairly evenly divided between a “Christian-democrat/Gaullist” party and a socialist party dominated by social democrats. This division always ensured that governments were formed promptly by whichever party had the most delegates. Electoral programmes were duly implemented, whether designed to placate the far-left (wealth taxes, the 35-hour week, 75% income tax) or the right (privatisation, later retirement, etc.).
The problem today is not only that both main parties seem to be in the process of imploding, but also that it is hard to know what each party will stand for in the upcoming election. As a result, parliament could conceptually be divided between four, or even five, main political blocks with little in common. In such an outcome, one can imagine the formation of some sort of “grand coalition”, made up of the center-right, the centre, and the social-democrat wing of a by then dead and buried socialist party. That would block both the far-right National Front and the extreme left from power. But the negotiations would be far from easy, and it is likely the markets would be jittery as the horse-trading unfolded.
So what does all this political uncertainty mean for markets? As mentioned, the economic momentum favoring Europe is not only strong, but also appears sustainable. Still, with the Sword of Damocles of French political uncertainties hanging over the markets, it may well make sense to put on a few hedges as we approach voting time. As we see it, the most obvious hedge would be to buy OAT puts or to short OATs outright.
Another would be to buy out-of-the-money puts on the euro (say with a strike of US$1.04). Any bad electoral result is likely to trigger a new, if short-lived, wave of euro selling and a US dollar rally. By the same token, bad news in France would likely trigger a yen rally as Japanese bond investors would do what they always do in the face of negative political developments: repatriate capital. And in turn, a rise in the yen versus the euro would cloud the profitability picture for a number of Japanese industrials and deep cyclicals, and likely trigger some short term Japanese equity market underperformance. In the same way, a weaker euro versus the US dollar would hurt industrials and other deep cyclicals in the US. In short, with the clouds gathering over France potentially threatening storms, adding buffers and protection into portfolios makes sense.