On Sunday April 23, the eyes of millions of Europeans will be on the outcome of the first round of French Presidential elections, as the vote is considered a test for the future of the European Union. A potential victory for Marine Le Pen and the National Front party would be perceived as a key geopolitical risk for the Eurozone as a whole, raising the risk of a Euro break up.
Ahead of this event, we believe that investors should consider five things:
1. Eurozone economy is in much stronger condition than twelve months ago. Economic surveys continue to report improvements in the euro-area economy and are consistent with firming growth dynamics. Buoyant domestic demand now seems to be coupled with a more robust global environment. The European Central Bank (ECB) is providing a substantial degree of monetary accommodation, and the global reflation trend has widely dissipated deflation scares, even if domestic generated inflation has not materialized yet.
Rising Eurozone Purchasing Managers Index (PMI)
Source: Bloomberg, as of March 31, 2017.
2. A referendum for Frexit (France Exiting the Euro) is not easy to call. Even if Le Pen wins, the French institutional set-up should be robust enough to limit her ability to call for a referendum on the Euro exit. It is extremely likely that her Presidency would be a “cohabitation” one where the President does not have a majority in the Parliament. The reason for this is that every election in France is based on two ballots, and in the second round National Front representatives traditionally have had a very low chance of being elected. Euro and EU membership in France are written into the Constitution; hence the procedure should involve the Prime Minister or some members of the Parliament proposing the constitutional referendum. But for the process to get submitted to citizens for a vote, it has to receive a majority vote by the whole parliament, which is very unlikely.
3. Initial market reaction of a Le Pen victory can be dramatic, but the European Central Bank safety net will likely protect markets from major disruption. Even if the scope for implementing her policies is quite limited, a Le Pen victory would be a shock for the Eurozone as a whole and would likely trigger a deposit flight from France, and sharp volatility in bond and equity markets. We could see a phase of de-risking from European assets, hitting European corporates, which have been so far resilient to the increased political uncertainty. However, we believe that ECB intervention and purchasing programs could avoid major disruption.
4. Hedging strategies are available to try to protect portfolios in periods of turmoil. Gold and the US dollar, in this environment, could be efficient hedging strategies ahead of heightened political risks.
5. Tactical opportunities may open up in the case of a Euro-friendly result. The spread between French government bonds versus the German bund started to widen when Trump was elected, as the markets started discounting the risk of an anti-establishment and populist wave spreading across Europe. Also, the French stock market has lagged since the start of the year due to the electoral risk. A pro-Euro vote could make French assets attractive also in consideration of two things:
First, France’s economy is highly exposed to the euro-area domestic demand and should benefit from the strong euro-area growth numbers.
France Exposure to Euro-Area Domestic Demand
Source: Thomson Reuters, Credit Suisse Research as of March 20, 2017.
Second, regarding the French stock index, its composition is more biased towards companies with global rather than domestic exposure, so its reliance on French domestic issues is limited and could even benefit from a weaker euro. Looking at the geographical reach of the French stock market benchmark, the CAC40 Index, in terms of revenue, we find that the French market is truly global, particularly within the areas of information technology, healthcare and consumer discretionary.
Breakdown by (Revenue %) of the CAC 40 Companies
Source: Morgan Stanley as of February 29, 2017.