Publication for professional investors April 2017 In-depth insights from NN Investment Partners. France: On the brink of a new era

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1 In-depth insights from NN Investment Partners FocusPoint France: On the brink of a new era In this FocusPoint we take a look at the candidates in the second round of the French Presidential election and their programs. We assess what the consequences may be of either Le Pen or Macron winning the election for financial markets, the French economy, and the European Union. We believe Emmanuel Macron will be elected President of France on 7 May If so, we expect a positive market reaction, because of his overall market-friendly policies, reformmindedness and strong pro-european stance If Macron wins, he may strengthen the Franco-German axis which has been the driving force behind European integration, even more should the Social Democrats win the German elections in September

2 France: On the brink of a new era The endgame of the French Presidential election is nearing, as on 7 May French voters will elect a new President. With the win of Emmanuel Macron in the first round and Marine Le Pen coming second, six decades of domination by France s two mainstream political parties has come to an end. The second round will be a runoff between the founder of the En Marche! movement and the leader of the National Front. In this FocusPoint we take a look at both candidates and their programs. We assess what the consequences may be of either Le Pen or Macron winning the election for financial markets, the French economy, and the European Union. We also explain why we think Emmanuel Macron will be elected President of France. If indeed he is, this could be a start of a strengthening of the Franco- German axis which has been the driving force behind European integration. It may be the start of accepting the idea of common responsibility among European policymakers, even more so should the Social Democratic party of Martin Schulz win the German elections in September. Marine Le Pen: restoring French sovereignty by leaving the EU and the euro Marine Le Pen, 48 years old, entered politics at the age of 18 by joining her father Jean-Marie Le Pen s party National Front, in She was first elected to political office in 1998 as a regional councillor in northern France. She later had the same role in the Paris region before returning to the northern rust belt in She has also been a member of the European Parliament since Since she succeeded her father as leader of the party in 2011, Le Pen has tried to clear the party of the anti-semitic image it acquired under the nearly 40-year leadership of her father. She has managed to reposition herself and the party by embracing a pro-welfare program, offering protectionist policies to shelter French workers from globalization, while maintaining an anti-immigrant and anti-euro focus. Le Pen has published her political program in a manifesto of 144 commitments for France. In the manifesto she puts the blame on Europe and globalization for France s slow economic recovery. To revive the economy she argues that France will have to get its economic, monetary, legislative and territorial sovereignty back by leaving the European Union, going back to the franc, limiting immigration and instituting protectionist measures. Le Pen wants to renegotiate France s EU membership and prefers to leave if she does not manage to rapidly change the bloc from inside. In that case she wants to hold a referendum on EU or euro membership and said she would resign if voters would choose to stay in the EU. Le Pen has also said she wants to introduce the franc in parallel to the euro. The aim is to face unfair competition, which simply means she wants a devalued currency to improve competitiveness. At the same time she wants to reserve the right to order the central bank to directly fund the Treasury by buying up French debt. If carried out, we believe these plans will turn out to be a disaster. The result will be an increase in French inflation (expectations) that will wipe out any initial competitiveness gain. What s more, all this will make the French debt burden completely unsustainable because the Treasury will receive tax revenues in the new devalued franc while the debt remains in euros. Alternatively, she can default on the debt and face very high sovereign borrowing costs for the increase in fiscal deficits triggered by the inevitable recession and her program of fiscal expansion. All this economic mayhem will be enhanced by deposit and capital flight out of France that will cripple the banking system. In addition to leaving the EU and returning to the franc, Le Pen wants to put French labour and products at the centre of the economy by implementing smart protectionism, through taxes on imports and by taxing companies that hire foreign workers. To make companies more competitive, she wants to reduce the tax and administrative complexity facing small and medium sized companies (SMEs). She also intends to reserve public purchases for French companies and prevent foreign investors from investing in strategic and promising French industries. Le Pen furthermore wants to increase purchasing power and consumption by establishing a Purchasing Power Premium (PPP) for low-income earners and people receiving low pensions, which would have to be financed by taxing imports. To increase consumer spending she also pledged to cut taxes for the three lowest income brackets and reduce the regulated gas and electricity rates. Finally, she promised to hire more civil servants (she proposes a 50,000 increase in armed forces) and increase public spending, especially on defence. GDP growth France versus Germany Emmanuel Macron: the business-friendly pro-european Emmanuel Macron, 39 years old, is a former Inspector of Finances in the French Ministry of Economy and investment banker at Rothschild & Cie Banque. As member of the Socialist Party he was designated deputy secretary-general under François Hollande's first government in 2012 before being appointed Minister of Economy, Industry and Digital Affairs in 2014 under the second Valls Cabinet, where he pushed through business-friendly reforms. In August 2016, Macron resigned from the government shortly after he founded his own progressive political movement, En Marche!. In November 2016 he formally declared he would run in the Presidential election. Macron has managed to emerge as a credible independent candidate, 2

3 positioning himself neither on the right, nor on the left with an appealing economic program, mixing centre-right liberal propositions and social protection features of the current centre-left administration. Macron s program suggests he intends to import the Nordic model into France. The essence of this model is a combination of structural reforms which make the economy more flexible and providing state support/incentives for an increase in investment and human capital. Macron plans a EUR 60 billion reduction in public spending over five years, which would partly be achieved by the non-replacement of 120,000 civil servant jobs. He proposes an overall cut in taxes, and a EUR 50 billion investment plan, putting particular emphasis on the need to increase France s competitiveness and on promoting innovation. His program has a large number of business-friendly measures. On the tax front, he has promised a corporate tax cut from 33.3% to 25% (in convergence with the European norm) and a decrease in the cost of labour financed by a 1.7pp increase in the CSG, a social contribution levied on broad income. Green taxes are also expected to increase. 80% of households would be exonerated from property taxes (worth ca. EUR 10 billion) while a flat tax of 30% on all capital revenue would be imposed. Macron projects an unemployment rate of around 7% (3%-points lower than the current level) by 2022, which would lead to significant fiscal savings. He insists in his program on training as a key ingredient to reduce unemployment, while he promotes increasing labour market flexibility and negotiations at company level to make working time flexible. He also wants to build a universal retirement system which allows all workers access to the same retirement rights. French unemployment rate is quite sticky (%) notably driven by François Hollande, would not help Greece in dealing with its debt. In June 2016, he criticized the austerity policies imposed on Greece, considering them to be unsustainable and calling for the joint establishment of "fiscal and financial solidarity mechanisms" and a mechanism for restructuring the debt of Eurozone member states. Macron is likely to become the next President of France Already for quite some time, polls have predicted that Le Pen and Macron would neither win a majority in the first round and would challenge each other in the second round. In this final round, Macron is predicted to beat Le Pen by a wide margin of around 60% to 40%. What makes it unusual this time is that the traditional parties candidates (the Socialist Party and the Republican Party) have both been eliminated in the first round. Le Pen has been high in the polls from the start with around 25% of voting intentions, but while her voter base is very loyal, she seems not capable of attracting many new supporters. And despite similarities with Donald Trump on themes like immigration and sovereignty, Le Pen is not an outsider, having been in politics for the past 30 years. Her electoral base has been tested often, but she has never managed to get more than around 30% of the expressed votes. Of course the polls might tighten somewhat in the run up to 7 May. They also still show a large percentage of voters who are undecided or may abstain. Hence, the tail risk of a Le Pen victory could still realise if there is a very high abstention rate and/or if she benefits from a very high degree of vote transfer. However, no party will support Le Pen in the second round, while both the Republican candidate Fillon and the Socialist candidate Hamon have urged voters to rally behind Macron in the second round. Macron is seen as sufficiently mainstream to gather a significant amount of additional support from the more traditional right or left voters who have seen their first choice candidate eliminated in the first round. Hence, the probability of an increase to more than 50% of the popular vote for Le Pen seems very limited. The President s powers may be limited without a majority in Parliament In case Le Pen wins the second round, we expect an immediate riskoff move in financial markets, given her ideas about how to restore French sovereignty and her stance on Europe. However, it is important to emphasize that in this hypothetical scenario, Le Pen would have very limited powers. In France, the Presidential elections are always followed by Parliamentary elections, to ensure that powers are not only in the hands of the President. Macron is the most pro-european Union of all initial Presidential candidates. He is calling for greater integration with the creation of a proper European governance structure with its own budget and fiscal policy. He also wants common defence funding to protect the borders of the EU. He wants to set European social rights by setting minimum standards for minimum wages, unemployment insurance, training rights, among others. In 2015, while discussing the Greek bailout referendum, Macron called not to cause "automatic ejection" of Greece from the Eurozone and "not to make a Versailles Treaty of the Eurozone". He believes that the Greek and European leaders coproduced the Greek government debt crisis, and that the agreement reached in the summer of 2015 between Greece and its creditors, Parliamentary elections will be held in June, also via a two-round election in which 577 members of Parliament (MPs) will be selected. Currently, Francois Hollande s Socialist Party has a majority (289 MPs) in Parliament, but according to recent surveys this is likely to shift. The Republican Party, now with 198 MPs, would gain a significant Parliamentary majority in the upcoming elections. Marine Le Pen s National Front has currently only 2 seats in Parliament and while the expectations are for a large increase (to around 60 seats), the National Front would still be very far away from a majority. Without a Parliamentary majority, Le Pen has to form a coalition government (the so-called cohabitation ). The President appoints 3

4 the Prime Minister, but he or she needs to come from the majority party in Parliament, most likely the Republicans. In the case of cohabitation, the President can be prevented from carrying out his/her program due to a lack of Parliamentary support. The President can also initiate referendums, but only if the proposition comes from the Prime Minister or either one of the two chambers of Parliament. All in all, there are many hurdles for Le Pen to call a referendum on EU membership or the euro, which we will not discuss in detail here. This does however not mean that Le Pen will not be detrimental to the French economy and French assets. Domestically, the reform momentum is expected to stall completely because of the cohabitation. Moreover, the French President has much power when it comes to foreign policy and Le Pen is unlikely to cooperate well with whoever the new German Chancellor will be. This is likely to deprive Europe of badly needed further progress on fiscal and banking union which is ultimately detrimental to its stability. If Macron wins the Presidential election, also his party En Marche! is not likely to get a majority in Parliament. In that case he thus has to appoint a Prime Minister who forms a coalition government. Traditionally, this has been a recipe for policy paralysis in France. Macron has to seek broad popular support for labour market reforms that are sure to meet resistance. Nevertheless, with the French political landscape clearly in flux there is a possibility that Macron could rely on a coalition of his own party and moderates from other parties who are willing to push through reforms. The fact that markets have been so nervous about a potential Le Pen Presidency is merely because of the implications it could have for the future of the European Union. After all, the Franco-German axis has been the driving force behind European integration and the success (or failure) of further integration is highly dependent on this Franco- German dynamic. In essence, the euro exists today because Helmut Kohl and François Mitterand decided to exchange German reunification for European monetary integration. During the euro crisis, France benefited enormously from this political dividend as its sovereign spread remained more contained than the Italian, Spanish and Portuguese risk premiums. Also deposit flight from the French banking system was hardly visible in , while it was a real problem in the other peripheries. The French political dividend was essentially about the fact that markets saw a much smaller risk of France breaking away. To some extent this turned out to be a selffulfilling prophecy (less pressure on sovereign and bank balance sheets), but up to a point it was also about the calculation that Germany would go to greater lengths to keep France in than it would for the other peripherals. This is probably still the case but if the French themselves decide to leave there is nothing Germany can do about it. This is why the risk of Marine le Pen becoming President is reflected in the probability that this political dividend will disappear, which is essentially what drives the French spread currently. Household and business confidence are on an upward trend European integration driven by the Franco-German axis We can conclude that much is at stake for France and the European Union on 7 May. While a Le Pen victory would very likely cause a negative market reaction, the market is expected to react positively on a Macron win, because of his overall market-friendly policies, reform-mindedness and strong pro-european stance, which many investors would view positively in terms of France and Europe if he becomes President. Markets already reacted very positively after the outcome of the first round, as the euro strengthened, the French government bond spread declined and the French equity market rose sharply. French spread falls after first round election result It is important to emphasise that France is not a typical peripheral economy for reasons other than the political dividend. French sovereign debt is just below 100% and the French banking system is in pretty good shape. Also, the long-run prospects for French growth are pretty good, provided the next President pushes through reforms as France has some rigidities in its labour and product markets. Many things can be improved, for sure, but France is in our view under no specific risk and has no major economic fragility. The upshot is that the continuation of the political dividend in French sovereign spreads will, not surprisingly, depend on political developments. In the near term the question is whether Marine le Pen can be prevented from becoming President, but in the more distant future the political dividend will depend crucially on an economic reform dividend, which in our view is best served by a Macron Presidency. In contrast to Macron, the political dividend would turn sharply negative immediately under Le Pen and erode further because of a negative economic dividend over time. 4

5 The Anglo-Saxon versus the continental European model It is interesting to see that, so far, the Anglo-Saxon economies have succumbed to populism, while on the European continent populists did not win in the Netherlands and are not expected to win in France and Germany either. This is rather striking to see, as the post-lehman recovery proceeded much faster in the US and the UK. Their unemployment rates have returned to pre-crisis levels while the European unemployment rate is still well above the average. On top of this, continental Europe also experiences more problems with terrorism and mass immigration. This points to the importance of other factors. The Anglo-Saxon neo-liberal philosophy holds that the market economy can be more or less decoupled from the political and social system and left to its own devices. Doing so is believed to yield beneficial economic effects which will foster social and political stability. Instead, however, it has led to rising income inequalities that have created substantial tensions which over the past few years have spilled over into the political arena. By contrast, the continental European or Rhineland model sees the economic structure as being inherently embedded in the social and political structure. This holistic view leads to the conclusion that there are many ways in which these systems influence each other and good policymaking should take this into account. One area where this becomes very clear is corporate governance, where there is a strong preference for the stakeholder model which stands in contrast to the Anglo-Saxon shareholder model. It is not a priori clear that this should necessarily lead to a worse growth performance than the Anglo-Saxon model (Germany did pretty well in terms of GDP growth per head and productivity performance). It does however lead to lower income inequality and social inclusion in general, which could have the effect of dampening voter revolt. we are all in the same boat together. More upside risk on this front could emerge in September if Social Democratic party candidate Martin Schulz would win the German elections. A social-democratic victory may well offer scope for more burden and risk sharing in the European region in exchange for more structural reform in countries such as France and Italy. Accepting common responsibility To be sure, voter revolt is happening in Rhineland economies because income inequalities have increased (albeit less than in the US and the UK) and the post-lehman recoveries have been pretty slow which has left debt burdens high. An important reason for this is that especially the hardliners in the German government have been averse to further steps in the direction of burden and risk sharing within the region and instead have focussed on enforcing common rules and fiscal austerity. This misguided idea that the burden of adjustment should mostly fall on the supposed sinners, being the peripheral countries, shows that European policy makers led by Germany still not fully get the core of the problem: we are in this mess because the core countries lent way too much to the periphery before This is a common responsibility as the periphery should have tamed its appetite for credit while core investors should have applied much better due diligence. As Macron has stressed this common responsibility earlier, he becoming French President could be an important step towards the acceptation of policy makers that Disclaimer The elements contained in this document have been prepared solely for promotional purposes and do not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any trading strategy. This document is intended only for MiFID professional investors. While particular attention has been paid to the contents of this document, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change or update without notice. 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