Could the French Presidential Election have a seismic impact on markets?

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1 Could the French Presidential Election have a seismic impact on markets? Forex and CFDs are high risk leveraged products that can result in losses greater than your initial deposit and you should therefore only speculate with money you can afford to lose. FX and CFD trading are not suitable for everyone. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions. You should first carefully consider your investment objectives, level of experience, and risk appetite and only invest funds you are prepared to lose entirely. For our full risk warning, please go to the end of this report. Ever since the UK voted for Brexit and the US voted in President Trump, there has been a sense that a wave of populism has been taking hold throughout the western democracies. With a series of elections in the major Eurozone countries this year, this is a wave that threatens to sweep through the very fabric of the European political bedrock. The Netherlands may have managed to hold back the racist, antiimmigration, anti-islamic movement that threatened in the form of Geert Wilders, however the voice of populism remains loud and an existential threat to liberalism throughout Europe. The French Presidential election is next on the agenda. The first round of voting is held on Sunday 3 rd April, with a second final run-off to be held on Sunday 7 th May, if there is no initial absolute majority for one candidate. Whilst National Font candidate Marine Le Pen has apparently always had the 0 Presidential campaign as her primary target, the wave of populism that has arisen with Brexit and Trump has thrust her into prominence for 017. Could Le Pen pull off a similar victory for the anti-establishment movement in France? We look at the state of play in the run up to the French Presidential election. We consider the candidates and what they stand for, the current polling statistics (for what they are worth), the chances of a Le Pen victory and the potential impact of the result on financial markets. 1

2 The candidates and what they stand for With months of jockeying for position, the first Presidential election debate comprised five candidates: Rebellious France Jean-Luc Melenchon; hard-left anti-austerity Socialist Party Benoit Hamon; left wing candidate that stepped into fill the void after incumbent President Hollande felt it best not to stand again after his such incredibly low approval ratings Independent En March Emmanuel Macron; centrist with socially liberal policies seen as probusiness Republican Francois Fillon; conservative, centre-right, seen as an almost Thatcherite proderegulation candidate who defeated ex-president Nicolas Sarkozy in the primaries National Front Marine Le Pen; far right with populist economic policies Realistically though, there are just three of the candidates who could become the next president, with Hamon and Melenchon surely just also-rans as their poll rating languish only just in double figures. In effect, the two left wing candidates (socialist Hamon and the even more hard-left Melenchon) are taking votes off each other, effectively ruling themselves out of the race in the process. Marine Le Pen, or Marine as she has tried to rebrand herself (in an attempt to detach herself from her extremist and discredited father Jean Marie Le Pen), is the leader of the hard-right Front National party. She is anti-eurozone and one of her flagship policies is to pull France out of the euro. However she is struggling with the fact that in recent polls, 7% of people are against French withdrawal from the Eurozone. In an attempt to soften the language, she is now stressing that she would hold a referendum on leaving the EU and the single currency within six months of becoming President. She recently said, We have to listen to the people and in the first Presidential debate she said that nothing would be done without permission.

3 Le Pen has also pledged to cut taxes for households and increase welfare benefits for workers. She would look to restore border controls and cut immigration by 80% to 10,000 per year. She would also look to prioritise French workers by taxing companies who employ foreigners, whilst promising to lower the retirement age and also make overtime tax free. Francois Fillon is on the right wing and is almost as Tory (i.e. like the UK s Conservative Party) as you can get in France. Arguably Thatcherite in his stance of attacking public services and social security, Fillon is looking to reduce the number of civil servants by 500,000, end the 35-hour working week (by introducing a 39 hour week for public sector workers), reduce public spending by 100bn and is a supporter of social conservatism. This would be an uneasy stance for the French to stomach as the population is traditionally far more left leaning than many Northern European countries and take pride in the state provision of their public services. Fillon is also interested in more integration with Europe on an intergovernmental basis, and would look to reduce immigration to a strict minimum through annual immigration quotas. He would look to cut corporation tax from 33% to 5%. Emmanuel Macron is the untested political outsider who has managed to position him as a reform candidate. He is calling for cuts to costs and bureaucracy in order to boost hiring. His six main priorities are education, work, economic modernisation, security, democratic renewal and international engagement. He is looking to liberate sectors of the economy whilst providing protections for all in a program that brings France into the 1 st century. Macron is looking to make moderate spending cuts of 60bn over 5 years, however he is also planning a 50bn French investment plan over the same time. This would include investment in agriculture, renewable energy, housing and extending internet coverage. Similar to Francois Fillon, he would also cut corporation tax to 5% (from 33%). With regards to Brexit, he would defend the integrity of the single market, whilst he believes in the need to propel the Eurozone forward. He supports greater co-operation within the EU on fiscal, environmental and social regulation. Macron would welcome refugees in need of protection.

4 Where has Macron come from? For months the perception has been that Marine Le Pen would be the candidate to pick up the baton for the populist movement that seems to be sweeping through western politics. However, this ignores a key reason behind why Donald Trump won in the US Presidential election. Trump was seen to be outside the political domain. He could constantly claim that he was not a member of the political establishment and that he would drain the swamp in Washington. Whilst not looking to be a direct comparison with Trump, with his En Marche ( On Our Way ) movement Emanuel Macron has now become the equivalent outsider in the French election. Macron is an independent candidate who is significantly lacking when it comes to political baggage. Source: Financial Times However, Macron s popularity has been climbing in recent months but looking at the poll tracker this appears to have come at the expense of Francois Fillon, whose popularity has waned at a similar rate. Fillon had looked a strong bet to make it into the second round at the turn of the year, but the mainstream vote seems to be swinging round to Macron. It is interesting to see that support for Le Pen has fluctuated very little in recent months and remains solid around 5% of first round voting intentions. But is Macron s apparent popularity all it is cracked up to be? The table below suggests that a large proportion of Macron s support could easily evaporate if he runs into difficulty in the final weeks of campaigning. Could this mean that the support he seems to have taken from Fillon begins to reverse? Perhaps his path to the second round is not as certain as the polls might suggest? Source: Elabe, from the Economist

5 What are the polls saying? 016 turned out to be a somewhat disastrous year for opinion polls. Despite their credibility seemingly at an alltime low, we look at how they are predicting the outcome of the French Presidential election, according to OpinionWay, a French opinion polling group, just under a month to go until the first round of voting. The graphic shows that there are five candidates realistically in the running, but even that can be whittled down to just three. Source: OpinionWay In the final few weeks to the first round, the rise of Macron has put him neck and neck with Le Pen which makes them the most likely to move into the second round run-off. Macron and Le Pen both tie for the lead, polling around 5% of the vote, with Fillon third on around 19% seemingly crucially unable to breach the 0% barrier.

6 Fillon is surely finished now isn t he? Francois Fillon has been fighting seemingly a losing battle for months as accusations of embezzlement have plagued his campaign. It is alleged that his wife, Penelope, and children were on his payroll as parliamentary aides. His wife is alleged to have been paid over 800,000 for work that she has supposedly never undertaken. The scandal has even taken on its own gate suffix, becoming known as Penelopegate. However, Fillon has fought on for months against the odds, but his woes do not end there. It has also now been alleged by a satirical newspaper Le Canard Enchaine that he has financial links to the Russian government. Whilst allegations of links to the Russian s did Trump limited harm in the US elections, could this be the straw that breaks the camel s back for Fillon? Well, it is curious, that whilst Fillon is languishing as third in the polling, he would still be expected to beat Le Pen in a second round run off. Perhaps there is still time for him to turn it round? Also, as Brexit and Donald Trump proved in 016, the pollsters can get things wrong. Also there is still time for Macron s popularity to blow up, whilst in the Netherlands, Geert Wilders share of the vote in the election was around half of his polling in the run-up. You never know. Who will make it through to the second round? There is no clear winner emerging through the polling for the first round election, something that would need over 50% of the vote. However there are some clear trends emerging that suggest the polls are increasingly moving towards a Le Pen versus Macron run off in the second round. For weeks, the erstwhile favourite, Francois Fillon has been fighting against accusations of corruption after it appears he paid his wife and family for work they did not do. Fillon s Republican party has been divided for weeks over whether he should be their candidate and this has all hit his prospects in the polls. Despite this, the expectation would be that in the absence of Emmanuel Macron, Fillon would still be the favourite in a second round run-off against Marine Le Pen. So conventional wisdom suggests it must be Macron versus Le Pen in the second round run-off. France has to decide whether it wants to become an introspective, anti-globalisation, anti-immigration country under a Le Pen presidency; or whether to be embrace Macron s Neoliberal view of an open and welcoming French society that is prepared to take a central role in pushing for closer integration in both Europe and the Eurozone. According to the polls on OpinionWay, it seems that Macron is heading to a fairly resounding victory if he can make it into the second round run-off. For that matter though, if Fillon were to make it into the final vote against Le Pen, he would also be the likely victor, currently running at around 60% versus Le Pen s 40%.

7 Source: OpinionWay But, could Le Pen actually win though? If Brexit and Trump has taught us anything, it is that the unexpected can, and does, happen in politics. A Le Pen victory would have to come against a scandal-ridden establishment candidate, something that Fillon apparently represents, someone who has been seen as having his snout in the trough. Le Pen is likely to find Macron as being too detached from the establishment to be able to sustainably pull on the populist sentiment that Trump was able to engender. Terrorism would bolster the Nationalists Another major terrorist attack could also be Le Pen s trump card (no pun intended). It could be regarded as distasteful to suggest, but it is in the terrorists interests to divide in the way that a Le Pen victory would provide. A major terrorist attack in front of the election has to be an elevated risk. You can be sure that the French security forces will be on ultra-high alert in the coming weeks. This time it s different, but is it? Le Pen disbanded her toxic father from the Front National and this has seems to have successfully helped to downplay the perception of the party s racist links. However, the Front National is still seen as holding views that push the limit of acceptability on immigration. Furthermore, can Le Pen s seemingly contradictory economic plan of increased spending and tax cuts, whilst threatening the French economy by advocating leaving the Eurozone, win over the mainstream electorate? It is interesting to see that the fluctuating fortunes of Le Pen s rivals do not seem to translate to votes for her in the polls. She has consistently now been stuck on around 5% of the first round vote, which suggests that whilst her support is stable, it could also be limited.

8 MARKET REACTION How to view the market risk Political risk can be measured in the direction of government bond yields. However, in isolation this can be somewhat distorted, especially in the wake of rising inflation expectations around the world in recent months. Yield curves around the world have steepened amid a sell-off in government debt. However, stress in the Eurozone can also be measured by a function of the yield spread versus the German Bund which is seen as a safe haven play. It has subsequently been apparent that there has been a positive correlation between the electoral prospects of Marine Le Pen (seen as high risk to the French economy) and the spread between the French 10 year and German 10 year yields. The chart shows that since Donald Trump s victory in November, the yield spread has widened significantly. Daily DE10YT=RR, FR10YT=RR 1/07/016-1/04/017 (GMT) French 10 year yield German 10 year yield Yield Auto Value Yield Spread Jul 16 August 016 September 016 October 016 November 016 December 016 January 017 February 017 March 017 Apr Auto The spread went from around 30 basis points just prior to Donald Trump s victory, to a high of almost 80 basis points in February. This was the widest the spread has been since November 01. This coincided with Le Pen extending a first round lead to around 6% on her rivals in the opinion polls. However, as Macron s prospects have improved, with him latterly deemed to have come out on top in the first presidential debate, in addition to him solid election manifesto, the spread has tightened. The spread is currently back to less than 60 basis points again. JP Morgan has modelled that a Le Pen victory which leads to France withdrawing from the Eurozone, would drive currency depreciation, increased inflation and the requirement for further deregulation. They believe this would drive French year yields spiking to 10%, whilst the 10 year yield (which is currently around 0.94%) would jump to 5.7%. A victory for Marine Le Pen would drive stress through French bond yields. Different scenarios: Where could the markets go? A Le Pen victory: SIGNIFICANT VOLATILITY According to opinion polls, Marine Le Pen is not expected to win and it would appear that the market is not prepared for the surprise. Subsequently, if Le Pen were to win, this would be the scenario that creates the most surprise for financial markets and volatility would be likely to spike higher.

9 The chart of one week EUR/USD implied volatility shows the market is not expecting a Le Pen victory, with volatility around the lowest it has been since just before Trump s victory in November. Just prior to Brexit, volatility jumped to over 19, whilst in front of the US election, volatility was at over 14. With volatility currently just over 7, it would suggest that the market is not prepared for a surprise Le Pen victory. This could widen in the run up to the election, but for now, markets appear to be surprisingly sanguine about the election. Daily EURSWO=R UK's EU referendum US election 18/0/016-0/04/017 (GMT) Price One week EUR/USD implied volatility Q1 016 Q 016 Q3 016 Q4 016 Q Auto EUR/USD the euro is likely to come under significant selling pressure as markets realistically need to start pricing for the prospect of a Frexit from the Eurozone. Parity would be a significant downside risk, whilst a move back towards $ should not be ruled out longer term. Bond yields French yields would spike higher as market expectations change to take account of the costs and enormous stress that would weigh on the French economy in the event of pulling out of the euro, devaluing the franc and increasing the debt burden. Yield spreads over German debt would subsequently spike higher. Equities French equities would come under significant threat, especially the French banks that would be holding all that French government debt that would be sharply falling in value. The negative sentiment is also likely to spread across Eurozone equities (such as the DAX) as a Le Pen victory would question the viability of the currency area. Other Safe haven assets such as gold and the yen would benefit from the uncertainty surrounding the prospects of the Eurozone. US Treasuries are also likely to be sought after, driving yields lower, especially at the longer end of the curve. The reaction on German Bunds could also be strongly positive, with yields falling. Bunds are traditionally seen as a safe haven play, whilst in the prospect of a Eurozone break-up, they would be even more highly prized. A Macron victory: MARKET SUPPORTIVE With Macron s polling prospects improving in recent weeks, financial markets have become far more sanguine about the outcome of the French Presidential election. This is reflected in declining French bond yields, support for the euro and positive moves on equities. These moves would likely be sustained on a Macron victory, because despite limited expectation of a Le Pen victory, there is still a degree of political risk currently priced into markets. EUR/USD The euro has already been performing well as the prospects of Macron s victory have improved in recent weeks. Macron is pro-europe and advocates extending the powers of the European institutions. This would help to bolster support for a move towards the fiscal integration and mutualisation of Eurozone debt and bond markets, something needed to make the Eurozone a longer term success.

10 Bond yields - French yields would fall as the political risk that comes with Le Pen s threats to pull France out of the euro recede. Expect a tightening of the French/German yield spread, possibly back towards the 0/40 basis points range that was seen during much of 015 and 016. Yields have already been falling in recent weeks as the prospects of Macron have improved, but this is likely to continue if he gets into the second round of voting. Equities Macron s proposed cut to corporation tax would be supportive for French equities. His fiscal plans will have a limited impact on the budget, but the prospect of a Macron victory has already helped to improve risk appetite that has been pulling the French CAC 40 into multi-year highs. Other Safe haven plays such as gold and the yen would be expected to underperform with the improvement in risk appetite. The reaction on German Bunds could also be interesting. With a reduced need for safe haven assets, Bunds may well be shunned and that would send yields higher. One other biproduct of a Macron victory could also be a potential underperformance of sterling. Macron is seen as being pro-europe and could therefore be a driver of a harder bargain when it comes to the Brexit negotiations for the UK. A Fillon victory: MARKET SUPPORTIVE TO RISK POSITIVE Fillon is not expected to win according to the first round polls. However, if he managed to scrape through into the second round run-off against Marine Le Pen, the expectation is currently that he would win. His victory would generally be seen as a market positive outcome, much due to the relief of defeating Le Pen, but also due to him being seen as a stable, centre-right politician. His corporate tax cuts, reduction in civil service jobs and public spending cuts would go down well with financial markets. Generally, it would be a similar market impact as it would be for Emmanuel Macron, but perhaps even more positive, as Fillon s Republicans could have greater chance of controlling Parliament after the National Assembly elections in June. Primarily though, either of Macron or Fillon would be supportive for financial markets. EUR/USD the outlook for the euro would be neutral to positive as a victory for Fillon would represent support for the sustainability of the single currency. Bond yields French yields would fall with the end of the threat to pull France out of the euro. The spread between French/German yields would tighten back towards the 0/40 basis points spread seen for much of 015 and 016. Equities As with Macron, Fillon s proposed cuts to corporate tax would be positive for French equities. The French CAC 40 currently seems to be well on course for a move back towards its all-time highs and whilst broader global market equities remain positive, the expectation that either Macron or Fillon are likely to be the next president has been supportive for market sentiment. Daily [.FCHI List 1 of 41].FCHI All time closing high 5,197 08/06/015-05/05/017 (PAR) Price EUR 5,100 5, ,000 4,900 4,800 4,700 4,600 4,500 4,400 4,300 French CAC 40 Index 4,00 4,100 4,000 J A S O N D J F M A M J J A S O N D J F M A M Q3 015 Q4 015 Q1 016 Q 016 Q3 016 Q4 016 Q1 017 Auto

11 Other Safe haven assets such as gold and the yen might find a reduced bid. The reaction on Bunds could be more extreme with Fillon as if France can shift right then the perception could be that there is less chance of Martin Shultz s centre-left Social Democrats winning in Germany. This would again be risk positive and safe haven Bunds could come under pressure, sending yields higher. N.B. Remember the French Parliamentary elections in June If there is a surprise result in the French Presidential election, traders will do well to remember that the President needs the backing of the National Assembly to help put policies into practice. The extremist nationalist party has always struggled in national elections, with Marine Le Pen s Front National party currently having just deputies out of 577 representatives in the parliament. Le Pen would subsequently struggle to get any controversial legislation through. However, Emmanuel Macron may also face a stumbling block here. The En Marche movement has never put anyone up for election, either nationally or locally. The irony is that the presidential candidates most likely to make it into the second round would both face significant difficulty in the coming months from a legislature that contain very few friendly faces.

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