Market Update APR French Elections: Basics for Investors. The Contenders

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1 Market Update APR 217 French Elections: Basics for Investors Julien-Pierre Nouen, Vice President, Lazard Frères Gestion, Paris 1 The French presidential elections which are scheduled for April and May have already defied expectations. Just last summer, the incumbent President François Hollande from the Socialist Party was expected to run for re-election. The only outstanding question at the time was whether he would face Nicolas Sarkozy or Alain Juppé for the conservative Les Républicains. Today, the socialist and conservative parties, which have governed for decades, look likely to be eliminated in the first round of voting. This would leave the second round contest to Marine Le Pen, a right-wing populist, and Emmanuel Macron, a relatively new figure in French politics who positions himself at the center of the political spectrum. A Le Pen victory could potentially cause a significant risk-off reaction in the financial markets, but we believe that scenario remains unlikely. Nevertheless, the widening spreads between French and German bonds seemingly show that markets have started to take this risk into account (Exhibit 1). Many market participants have justifiably focused their attention on the upcoming French presidential elections. There is the tail risk that the new French president could bring about a referendum concerning s possible withdrawal from the European Union. However, it is more likely, in our view, that a more centrist winner will seek to reform, which could be positive for Europe s markets and politics. In this paper, we review the contenders, their agendas, their likelihood of winning, and explain why the parliamentary election scheduled in June may be even more important than the presidential election. We also discuss the potential risk of the so-called Frexit and describe a baseline scenario for a centrist president who would look to address some of s structural headwinds. The Contenders Exhibit 1 Markets Appear to Be Taking Account of Election Risk French vs. German Spreads (bps) As of 7 April 217 Source: Bloomberg 1-Year Yields 2-Year Yields The official list of French presidential candidates numbers eleven, but only five are currently polling above 1% (Exhibit 2). Based on polls at the time of writing, Marine Le Pen and Emmanuel Macron are likely to make it to the second round, where Emmanuel Macron is the favorite to win. However, we note that a large number of voters appear to remain uncertain of their choice. Marine Le Pen took over the far-right National Front party from her father, Jean-Marie Le Pen. She has been largely successful at broadening the base of what was before principally an anti-immigration party. She adopted a statist, anti-globalization, welfare-enhancing stance that has helped the party win many votes among working class voters. Her platform is best summarized by her stated willingness to force s exit from the euro zone. She has also stated that she would like to roll back a significant amount of the latest liberalization measures put in place. LR28166

2 2 François Fillon is the candidate for the right-of-center Les Républicains through primaries late last year. His platform to improve growth and public finances draws inspiration from Margaret Thatcher s transformation of the Kingdom: e.g., lower taxes especially for corporations, less workers protection, and a significant reduction of the number of civil servants. Fillon is the most politically experienced candidate he was prime minister under President Sarkozy but he faces legal charges for allegedly providing a fake job to his wife. The clear frontrunner before the scandal, his ratings have since fallen dramatically, leaving him third in the polls. Emmanuel Macron is something of a novelty in. He is the first candidate since Charles de Gaulle that is likely to make the second round of the presidential election without ever holding an elected office. He started as an advisor to François Hollande, was designated minister for economy, and resigned last summer to launch his bid for the presidency. He has positioned himself at the center of the political field. The Nordic model inspires his platform: he wants a more flexible labor market and, at the same time, broader welfare protection. His program also aims to reduce the weight of the state in the French economy. Benoît Hamon, the candidate of the Socialist Party, defeated former Prime Minister Manuel Valls in the primaries. He stands on the leftist wing of the Socialist party and his platform is based on the idea of tax and spend. He has stated that he would like to reform the Stability and Growth Pact to allow for more spending and some renegotiation of debt in Europe. His main idea, the creation of a universal income, has been watered down, but it retains support from the reformist wing of the socialist party. Some members of this wing have already joined Emmanuel Macron; others have openly voiced criticism of Hamon s political views. Exhibit 2 Polling Averages First Round (%) Nathalie Arthaud Left Philippe Poutou Second Round (%) Emmanuel Macron Jean-Luc Mélenchon Benoît Hamon Marine Le Pen Emmanuel Macron Jean Lassalle François Fillon Nicolas Dupont-Aignan François Fillon François Asselineau Right Marine Le Pen Marine Le Pen Jacques Cheminade Average of latest poll data collected through 31 March 217 Source: Cevipof, Harris Interactive, Ifop Fiducial, Kantar Sofres, Odoxa, Opinionway Jean-Luc Mélenchon is the most significant candidate of the far left. A firebrand and consummate public speaker, he believes the Socialist Party is on the verge of disintegrating, and wants to be at the center of the rebuilding process. He wants to roll back recent liberalization reforms and increase public spending. He is also much more skeptical of the European Union than Benoît Hamon, as he also supports a referendum on the euro and an exit from NATO. His good standing in the TV debates has helped him overtake Benoît Hamon in recent polls. The Presidential Election Is Drawing Attention, but the Parliamentary Elections Are Probably More Important The first round of the presidential election will take place on 23 April. The two leading candidates will then oppose each other in a second round on 7 May. The presidential election has the highest estimated turnout: 8% 85% of eligible voters have participated in past presidential elections, but polls are forecasting a record low level of participation as the French people are deeply unsatisfied with the campaign. The victor takes office a few days later and nominates a prime minister, who is in charge of forming a government. On 11 and 18 June, two rounds of parliamentary elections will take place to nominate deputies to the National Assembly (Assemblée Nationale) the lower chamber. In the past, these elections have always resulted in a majority for the president s party, but there is no guarantee this will happen this time. Finally, in September, half the Senate will be re-elected through an indirect vote of grand electors (mostly local government elected officials). The National Assembly has the power to rule on most governmental matters, but the Senate approval is required to pass constitutional changes.

3 3 Each of the 577 National Assembly deputies is elected by a single-member constituency through a two-round voting system. The main difference with the presidential election is that more than two candidates can stand in the second round, provided that more than 12.5% of registered voters cast their ballot for them. In the past, thanks to this voting system, the bipolarization of French politics and political agreements between parties on the same side have always led to clear majorities. But the French political system seems to be undergoing a reshuffling, with the emergence of new political forces and deep tensions inside parties, such as the Socialist Party. As the French electorate seems to be much more splintered, the elected president might end up without a majority of deputies to govern. Without a majority, three scenarios could happen: a coalition, a minority government, or a cohabitation. The first scenario is likely to happen if Emmanuel Macron is elected. Without a structured political party to support him as his political movement En marche is just a few months old he might be short of a majority. He has already stated that he would be willing to rely on a coalition of the willing. The National Front is still seen as toxic by a majority of the French population and, even if the party was boosted by the election of Marine Le Pen, it would very likely fall short of a majority. The second scenario occurs when minority parties are unable to unite against the party with most votes. The party with the most votes might govern with the abstention of a somewhat important portion of the opposition parties, as is happening now in. The last scenario, where the president and the government are not from the same political party, has happened three times when the presidential mandate was seven years long (in , , and ) but never since the presidential mandate has been shortened to five years to coincide with the parliamentary mandate. Those cohabitation experiences are interesting as they show that the French presidency, despite representing one of the most powerful elected offices in the world, is in fact left with few powers without parliament on its side. As the parliament has the ability to overthrow the government through a vote of no confidence, a refusal by a president to select a prime minister from the winning party would likely lead to gridlock. The Real Risk: Will Go down the Road of Frexit? Both François Fillon and Emmanuel Macron appear to be market-friendly candidates. Both are also committed to significant reforms of the French economy, although with different flavors. As mentioned earlier, Fillon has more of a Thatcherite political platform, whereas Emmanuel Macron s political platform appears based on the Nordic model. Unlike other candidates, both have stated a desire to cut the deficit and to bring down debt, which is still relatively high (Exhibits 3 and 4). Despite a recent surge, current polling suggests that candidates from the far left are unlikely to pass the first round of voting. The scenario that appears to worry the market is the election of Marine Le Pen, as it would likely set in motion towards a referendum on membership of the euro zone, causing investors to worry about the potential risk that their euro-denominated assets might suddenly become franc-denominated. Based on current polling, it appears that Marine Le Pen will easily reach the second round but she is likely to lose against other major candidates. Nevertheless, in a politically charged environment, with voting intentions being more volatile than in the past, the potential for a Le Pen victory cannot be totally discounted. Exhibit 3 The Market Would Welcome Candidates Who Can Address s Deficit Exhibit 4 s Government Debt Is Another Economic Point to Tackle Government Net Lending as a Share of GDP (%) Government Debt as a Share of GDP (%) Euro Zone Euro Zone As of March 217 Estimated or forecasted data are not a promise or guarantee of future results. Source: AMECO database As of March 217 Estimated or forecasted data are not a promise or guarantee of future results. Source: AMECO database

4 4 A core part of her political platform is for to reinstate the franc as its currency, as part of a wider push for sovereignty. Documents released by her campaign insist that the exit would be negotiated and part of a complete overhaul of the relationships between and the European Union. Marine Le Pen has said that, under her presidency, would try to negotiate an exit during a six-month period before calling a referendum about Frexit. Meanwhile, if elected, she has pledged to immediately launch a referendum on electoral and constitutional reforms. Amongst other subjects, the proposed referendum would address the question of greater proportionality in electing the National Assembly. With a majority premium, this would dramatically increase the probability of a National Front full victory in latter elections. This first referendum would also modify the law on other referenda. Indeed, even if Le Pen wins the presidential election, the current voting system will make it very difficult for her to win a majority and to implement her proposed platform. As a consequence, several questions arise regarding Le Pen s ability to call a referendum. Two articles of the French constitution provide the legal basis for this. Article 89 is the most legally sound basis for changing the constitution but it requires the reform to be approved by 6% of the Parliament (National Assembly and Senate together) or by a simple majority in each chamber and by a majority of the population in a referendum. As the Senate is not likely to be won by the National Front, it follows that Marine Le Pen could not use Article Alternatively, according to Article 11, a referendum can also be organized on a simple proposition from the government to the president, followed by a discussion in the parliament. It was originally targeted to a specific number of subjects but not to change the constitution, but Charles de Gaulle used it twice for this purpose in 1962 and In 1962, he succeeded in changing the presidential election to a direct vote. Seven years later, his Senate reform was voted down, causing his resignation. At that time, the constitutional council decided not to overrule the vote based on the principle that the popular vote carries more weight. It is not solid legal ground to organize a referendum, but it might be the only way for Marine Le Pen to reach her goal. Therefore, right after the opening of the new parliament, or sooner if an extraordinary session is called, Le Pen s National Front interim government would likely propose the first referendum. The government would probably be voted out by the parliament if she does not have a majority, but as the vote can only take place 48 hours after the motion of no-confidence has been introduced, it would leave enough time for the president to accept the referendum proposal and launch the process. The National Front party has stated that it wants constitutional reform to modify Article 11 to enable the president and the government to bypass the parliament, if necessary. Modifying Article 11 would considerably reinforce Le Pen s ability, if elected, to hold a Frexit referendum that would otherwise have needed authorization through Article 89. At the end of the six-month negotiating period, without any agreement with the European Union, which, in our view, is the most likely scenario, the National Front party has said that it would call for a referendum on the European Union membership. According to a recent poll, 72% of French people want to stay in the European Union. 3 Marine Le Pen has declared that if she lost such a referendum and stayed in the euro zone, she would step down. At this time, we believe Frexit remains a very low probability scenario, but if the next elections were to increase its probability, markets would certainly start to price it through higher risk premiums on French assets, especially French bonds. For equities, we note that 8% of sales from the CAC 4 companies come from outside of and 5% outside of Europe. As observed right after Brexit, share prices in many British companies with significant foreign exposure, such as commodity producers or pharmaceuticals, adjusted relatively quickly with currency movements by rising. On the contrary, companies geared towards the domestic market underperformed significantly. In, we believe domestic players could potentially suffer as well. For example, retailers might be under pressure, as their cost would increase and a National Front government might pressure them not to pass these increases to consumers. Of course, financial institutions could also suffer significantly because they would have to sell their holdings of French government bonds, whose redenomination would amount to a default. The Base Line Scenario: A Reformist President Faced with a Structurally Challenged Economy in a Cyclical Recovery While we recognize the risks of a National Front victory, we believe it is more likely to end up with a president with a constructive reformist agenda. These potential reforms would seek to address a series of structural headwinds that have held back the French economy. Over the last few years, generated average economic performance. It did not perform as well as the German economy, but it did not follow s path of very weak growth (Exhibit 5). is much less exposed to global trade than, so it was less impacted by the global financial crisis. Its economy was not as imbalanced as s, and its banking sector was in better shape, so it did not suffer as much pressure during the euro zone crisis, but it did not rebound as much afterwards. However, this election may have a significant impact on s economic status.

5 5 Exhibit 5 s GDP Growth Has Been Close to the Euro Zone Average GDP (1=27) 12 Exhibit 6 Confidence Is Picking Up Y/Y Change (%) 6 Index Euro Zone GDP growth [LHS] Economic Sentiment Index [RHS] As of March 217 Source: AMECO database As of 28 February 217 Source: Bloomberg is benefiting from the global cyclical uplift, with indicators of confidence at the highest level since 211 (Exhibit 6). The European Commission expects French GDP growth to accelerate from 1.2% to 1.4%. This has allowed the unemployment rate to start falling but not as rapidly as elsewhere in the euro zone. A challenge facing is a lack of competiveness, which has gradually eroded the macroeconomic balances of what was once a relatively sound economy. This lack of competiveness is visible in the evolution of the trade balance, where the deficit has a tendency to increase as soon as domestic demand is buoyant. Despite the combination of a very accommodative policy in a country with solid banks, lower oil prices and a lower currency, growth has not accelerated meaningfully over the last few years. According to economic research, we believe this lack of competiveness can be attributed to both cost and non-cost factors. Apart from particularly strong sectors such as aerospace, luxury, and wine, French exports do not have a lot of pricing power, and cost competitiveness suffers from high labor costs and high non-tradable goods and services prices. The high labor cost can be explained by the fact that a large share of the funding of the extensive social protection system comes from social contributions, which increases the cost of labor (Exhibit 7). This comprehensive social protection is one of the main reasons why government spending is so high in (Exhibit 8). As in other advanced countries, aging is likely to exert a significant pressure on government spending in the years to come. High non-tradable goods and services prices also weigh on French competiveness. The lack of competition and a high level of regulation (Exhibit 9) has pushed up the cost of inputs for many companies, putting pressure on exporters margins. These lower margins also lower the internal financing of corporations, increasing Exhibit 7 Social Contributions Increase French Labor Costs Social Contributions as a Share of Gross Income (%) Belgium Sweden OECD Average As of 215 Data include employers and employees contributions. Source: OECD Kingdom States Exhibit 8 Generous Social Programs Lead to Elevated Government Spending in Government Spending as a Share of GDP (%) Denmark As of 215 Source: OECD Belgium Sweden Kingdom Ireland States Denmark Health and Social Protection Other Ireland

6 6 their reliance on debt. Another consequence has been to divert corporate investment towards real estate instead of productivity-enhancing capital expenditures. According to the World Robotics 216 Industrial Robots report, the number of industrial robots shipped to French companies last year was 15% of what was shipped in and 5% of what was shipped in. These structural impediments are well known, but the will to address them has been lacking over the years. François Hollande, who described himself as a social-democrat, had been elected on a very leftist program in 212 ( My enemy is the realm of finance being one of his most successful mottos during the elections), started his term by increasing taxes significantly, which brought the French economy to a halt. Subsequently, his government switched to more supply-side reforms to the dismay of many of his voters and of many socialist deputies who termed themselves frondeurs ( the rebels ) and tried to oppose this turn. Emmanuel Macron was instrumental in this policy, which culminated in the passing of the El Khomri law, enabling firm-specific working conditions agreement to take precedence over industry-wide arrangements. Despite significant demonstrations, the law passed. The election of Emmanuel Macron or François Fillon, provided they get a parliamentary majority to work with, could step up the pace of reforms, which we believe would be a good thing for the French economy and for French assets. It would also probably hasten monetary policy normalization by the European Central Bank (ECB). Other scenarios would be viewed negatively by many market participants, ranging from the election of Benoît Hamon, which would be mildly negative, to the election of Marine Le Pen, a clear negative, and the election of Jean-Luc Mélenchon standing in-between. The implications of a Le Pen victory were covered in the preceding section, but as polls have tightened recently between the four main candidates, the election of Jean-Luc Mélenchon is now a possibility worth contemplating. Even if he will also encounter difficulty gaining a parliamentary majority, his anti-market views around high taxes and nationalizing private enterprises can bring about further market volatility. Exhibit 9 Has a Heavier Regulatory Burden Relative to the Main European Economies OECD Product Market Regulation Index Sweden As of 213 Source: OECD Ireland Belgium Denmark Kingdom More Regulation Conclusion The French elections matter because there is the potential to elect a party that would like to see leave the European Union. While this scenario remains improbable, in our view, it cannot be fully discounted. However, we believe there is a much more significant likelihood that the elected president will be willing to reform. The implementation of these reforms could put in a better situation and improve its standing with, thus enabling a more balanced leadership for the European Union. Within financial markets, if Marine Le Pen loses, we believe it could potentially lead to an improvement of European assets, as it would clear the political timeline until the next Italian elections. Investors could thus focus on the improvement in the European economy and in corporate earnings.

7 Market Update This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Lazard Frères Gestion is the French asset management subsidiary of Lazard Group LLC. Lazard Frères Gestion is operationally independent from, and its employees do not provide investment advisory services to, Lazard Asset Management LLC. Mr. Nouen s insights are offered for information purposes only. 2 Only half the seats of the Senate are to be renewed. As the National Front has only 2 senators out of 348, they would need to get all the seats. 3 Elabe, 9th March Important Information This material was authored by Lazard Frères Gestion, an asset manager affiliated with Lazard Group LLC. Published on 22 August 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 17 April 217. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit for the specific Lazard entities that have issued this document and the scope of their authorized activities.