Here’s What’s Changed: “Markets Might Not Have To Wait Two Weeks To Sell Off”

It’s probably safe to say we’ve reached something that approximates “peak” French election analysis on Wall Street.

No one wants to be the macro (or rates or FX) strategist that didn’t weigh in and/or recommend a hedge or a trade.

Similarly, everyone is trying their hand at palm reading. Every poll is parsed. Previous election results are scrutinized. Anything to avoid what happened with Brexit and Trump, when everyone (including the pollsters themselves) failed miserably when it came to predicting outcomes. No one is taking much solace in the fact that just last month we dodged another (blond) populist bullet in the Netherlands and indeed that’s probably because the outcome here is far less certain (“Geert risk” was falling into the Dutch election while “populist risk” is rising into Sunday’s first round in France).

This morning, Citi is out with their latest attempt to make sense of things and I suppose, given how big of a deal this is, any incremental information is worth highlighting.

But before we get to that, here’s the latest from a reader who regularly updates us on his take. So far, he’s been remarkably prescient…

A safe pair of hands ?

The elections in France earn average but not great coverage worldwide

This is understandable, were it not for the uncertainty highlighted by the polls, with no less than 4 ‘front runners’ sharing more or less equally 90-92% of the vote (with about 8-10% split between the other 7 candidates)

This is troubling because 2 of these front runners have crafted an engaging populist discourse and seductive policies for voters who feel let down by the whole world and are eager to ‘regain control’ of their destiny… This may sound familiar, does it not ?

The difference with UK and US (and Dutch and German) recent political shifts is in the number, with two front runners mining discontent and hoarding more votes (percentage wise) than in any other democracy

Next Sunday the 2 populist candidates are not expected to come out on top because, ultimately, France is a conservative country but… a surge in votes from the young targeted by Mr Melenchon (extreme left) as well as Ms Le Pen (extreme right) cannot be discounted.

Looking for a ‘safe pair of hands’, the French voter are expected to turn to Mr Fillon and Mr Macron – and either one should come out as challenger of Ms Le Pen in the second round of this election

Mr Fillon (traditional right with catholic coloring) is currently leaning to his right with ‘law and order’ policies – if he comes out ahead in the first round, he will be supported by Mr Macron in the second round by smoothing his more radical proposals – in summary, nothing much changes

Mr Macron is currying support left of center, and as challenger of the French system without a true electoral base, his position is weaker than Mr Fillon – if he comes out ahead, he too will benefit from support from the ‘traditional’ right and from Mr Fillon – again, nothing much changes

Mr Fillon has regained momentum after revelation of his dismal personal financial gains and Mr Macron has been losing steam

These two candidates are now in a tie

But again, nothing much changes…

And here, as promised, is Citi’s latest.

Via Citi

What The Markets Care About: Pro-EU or Anti-EU

Whatever happens, this election heralds a period of change for the euro area‘s second largest economy. The candidates are offering a broad range of policies, most of which suggest a departure from the Hollande presidency. But most importantly for markets, there could be a radical reassessment of the French relationship with the EU.

Pro-EU: Macron/Fillon The first and more likely outcome is that voters choose a mainstream president (Macron/Fillon) that could deliver reforms to some of France’s structural problems, perhaps by reducing taxation and red tape for businesses. These candidates generally promise to maintain the status quo with the EU. This offers a benign outcome for financial markets.

Anti-EU: Mélenchon/Le Pen Alternatively, French voters could choose one of the more radical candidates (Le Pen/Mélenchon). Although they come from the opposite ends of the political spectrum, both threaten France’s membership of the EU. Any associated exit from EMU would represent an existential challenge to the single currency project and a systemic threat to global financial markets. While a Le Pen or Mélenchon victory still looks like an outside chance, it is not negligible. That’s why we are more nervous about the French election than we were about the outcome of the UK’s referendum last summer. France leaving EMU represents a much bigger risk for markets than the UK leaving the EU.

More Hurdles To Overcome Even though markets are likely to take an anti EU election outcome badly, this does not mean that French euro exit is inevitable in our view. On 11 and 18 June, legislative elections will renew all the 577 seats in the lower house. Depending on its composition, the new President will then nominate a Prime Minister to head the government. The PM will need to obtain the backing of a majority of MPs to win a confidence vote in the lower house following his/her first general policy speech. This offers a potential block to anti EU policies. And even if an EU referendum does happen, it is not inevitable that the French people will vote out.

What Polls Are Saying With only a few days to go, there are four candidates polling around the 20% level. Macron (pro EU) and Le Pen (anti EU) are the two candidates most likely to go through to the second round. But Fillon (pro EU) and Mélenchon (anti EU) are closing in (Figure 1).

Citi’s European Economists also highlight closing in levels of “Expected Minimum Threshold” for first-round votes (measure derived by multiplying the average daily first round voting intentions with voters’ certainty of choice). Le Pen leads on this measure although has slipped in the last two weeks. Mélenchon also has positive momentum, albeit from a low base (Figure 2).

Citi

We had previously thought that the markets wouldn’t know if France has chosen a pro-EU or anti-EU president until the second round on May 7. However, recent shifts in the polls raise the prospect of Le Pen and Mélenchon coming out top in the first round, leaving voters choosing between two anti-globalisation, anti-EU and proRussia candidates on May 7. Markets might not have to wait two weeks to sell off.

Citi’s base case is Macron to win with a probability of 35%, on the view that if he qualifies for the second round, his margin of victory against any of the other candidates looks comfortable. Conservative candidate Fillon is our alternative scenario with a 30% probability. We put 25% probability on a Le Pen presidency. Mélenchon’s sharp rise in polls means he has a 10% probability. That gives a 65% likelihood of a risk-on, pro-EU final outcome and 35% probability for a risk-off, antiEU outcome. A market-benign outcome still seems most likely but there is a meaningful risk that something more worrying happens.

Government Bonds EMU worries traditionally play out in the sovereign bond markets. The French election is no exception. OAT spreads (vs Bunds) have been tracking the probability of Le Pen or Mélenchon winning the presidency closely (Figure 3). Other peripheral bond spreads have also been widening, most notably in Italy. In a risk-off outcome to the election, we are likely to see capital flight from French (and periphery) bonds into German bunds. Our fixed income strategists think a 200bp OAT-Bund spread (currently 65bp) is possible. This is consistent with previous occasions of severe EMU stress. However, the significant rise in uncertainty, the risk of redenomination and the prospects of reigniting a fully-fledged sovereign debt crisis might prove even more complex than 2011-2012. In a risk-on outcome (pro-EU), they think their current base would be valid with OAT-Bund spreads likely to move back down towards 35-40bp (65bp currently).

FX While an adverse election outcome is likely to trigger capital flight from the periphery to core markets, it is also likely to leave Eurozone completely. This should put downward pressure on the euro. According to our FX strategists, a risk-off outcome (especially if it is combined with a majority in the French parliamentary elections in June) is likely to push the euro towards parity against US$. After the initial knee-jerk action, things become less clear. They highlight the possibility of euro trading like a quasi Deutsche Mark if Frexit is priced in as the Germanic core weight in the euro increases. In a risk-on outcome, the impact on EUR/US$ would be limited with some scope for the single currency to rally near term before US fundamentals kick in later in 2017.

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Credit Our credit strategists highlight that French election and the risk of Frexit could be far more damaging to the European credit market than Brexit was. They are not subscribers to the view that the market sells off against the prospect of a political risk event (Brexit, Trump) but rallies on its realization. In a risk-off outcome, they think spreads on IG-rated French corporates (currently 76bp) can rise by 30-40 bp in the immediate term based on comparisons to 2011- 12. Non-French euro-denominated corporate credit spreads are likely to widen by at least 15bp, with a greater impact on financials rather than non-financials and a reaction that might be 2-3 times as bad in the periphery as in the core. At the same time, they expect the ECB to step up its intervention in markets, with an increased pace of buying helping to cap selling pressures. In a risk-on outcome, Citi credit strategists think the impact would be minimal with no disruption to the current market regime. They have been cautious on the asset class forecasting negative total returns. IG is the expected outperformer in both the US and Europe.

Ultimately, here’s what Citi says you can expect across assets depending on who comes out ahead:

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