“This Time, The Experts Aren’t Exaggerating”: A Former Goldmanite’s Warning To Markets

You might already be tired of hearing about French elections and the outside possibility that Marine Le Pen could emerge victorious.

That’s too bad, because you’re going to be hearing a lot more on the subject over the next several weeks – and not just from me. Indeed the entire sellside is awash in coverage and the recent allegations of embezzlement and corruption leveled against Francois Fillon have ensured that the media is on board as well.

I’ve talked at length about what a Le Pen victory would mean for markets. For anyone who missed the recent coverage, here are the relevant posts:

There’s quite a bit of political analysis in those pieces, but despite my aversion to Le Pen’s politics, my main concern is, as usual, markets. Given that, I’m not particularly enamored with the idea of having to sort through a €1.7 trillion sovereign default.

When it comes to Le Pen and markets, more than a few analysts have warned investors against assuming that a National Front victory in France would be shrugged off by stocks as easily as the Brexit vote and Trump’s November triumph. “We would be careful about applying the lessons of 2016 to 2017,” Citi warned, earlier this week. “The key difference is the credibility of the central bank backstop.”

In other words, you know that $400 billion in quarterly central bank liquidity that you’ve gotten used to over the past eight years? Yeah, well it looks like that’s going to be fading away. That has real implications for the market’s resiliency.

In any event, I wanted to present a few excerpts from a pretty good piece in FT by Gavyn Davies – former head of the global economics department at Goldman Sachs from 1987-2001, and chairman of the BBC from 2001-2004 – entitled “President Le Pen – Small Risk, Big Shock.” The argument, essentially, is that markets are overestimating her chances of winning, but grossly underestimating how bad it would be if she did. Enjoy.

Via FT

It has been clear for a while that the most important political risk to global financial markets in 2017 will be the possible election of a President Marine Le Pen in the second round of the French elections on 7 May. Last week, this risk came into sharper focus when a small change in the odds of her winning the Presidency caused a sudden widening in Eurozone bond spreads, with the France-Germany spread reaching about half of the average levels seen during the euro crisis of 2011.

Investors have now become accustomed to political shocks driven by swings towards populism, notably in the UK and the US last year. These experiences have led some investors to conclude that a third “populism” surprise is quite likely in France because “no-one can believe the polls any more”. But they have also tended to add that “Brexit and Trump did not disrupt the markets, so Le Pen would not do so either”.

Both of these inferences are wrong. The risk of a President Le Pen is far lower than the ex ante risk of Brexit or President Trump was last year, but the consequence of her winning would be far worse. This time, the “experts” are not exaggerating how bad it could be for markets.

Why is Marine Le Pen unlikely to win the French Presidency, when she is in the lead in the first round of the contest, according to many recent polls? The answer is fairly obvious. Although she may win a small plurality over her several opponents in the first round, the anti Le Pen vote should coalesce in the second round, so she will lose to any likely alternative candidate in the run off.

While about a quarter of the electorate make her their first choice for the Presidency, about 60-65 per cent prefer anyone else but her in the second round. Under the French two-round voting system, the 35-40 per cent ceiling on her likely vote will stop her winning.

The only outcome that would genuinely trouble the global markets is a victory for Le Pen. Matthieu Walterspiler, the French strategist at Fulcrum, reckons there is still only a 10-15 per cent chance of that happening. That is a far lower risk than the likelihood of votes for Brexit or President Trump in 2016, both of which appeared only mildly improbable ahead of the event. Therefore, the shock would be much larger.

Now let us enter the very unlikely territory where Ms Le Pen is triumphant. Would this be like Brexit, a much feared event that had little immediate effect on markets (other than sterling) when it happened? I think not.

Marine Le Pen would ascend to the Presidency within a week, perhaps giving the National Front enough momentum to win a majority in the National Assembly elections on 18 June. She would need that majority to call a referendum on French membership of the EU, including the euro, possibly in the autumn.

Polls have traditionally suggested that France would vote about 55-45 in favour of staying in the EU but, in these political circumstances, who knows? The markets would obviously need to price in a non negligible risk that France would exit the euro, possibly taking many or all other members with it.

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