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French populist threat to the Eurozone


French populist threat to the Eurozone

Jeffrey Sacks

By Jeffrey Sacks

Head - EMEA Investment Strategy

February 28, 2017Posted InInvestments, Foreign Exchange, Equities and Investment Strategy

The first round of the French presidential election will take place on 23rd April, with the second and final round on 7th May. A victory for the current centre-left favourite, former Minister of the Economy, Emmanuel Macron, could be positive for the EU, given his desire for greater economic and monetary integration. His main rival, Marine Le Pen of the far-right wing National Front, is a vocal Eurosceptic, who could prompt an EU and Eurozone crisis if she won.

Marine Le Pen’s agenda, outlined in her recent 144-point plan, includes clawing back national sovereignty from the EU and abandoning the Euro in favour of a new Franc within six months of taking office. She is leading the polls for the first round, on 28%. But a recent poll by Odoxa/Dentsu-Consulting showed centrist Macron would beat Mrs Le Pen in a run-off by 61% to 39%. That said, there are reasons to be cautious, not least because there have already been various political surprises in France over recent months.

The conservative François Fillon has fallen from grace within the centre-right camp following accusations of misuse of state funds. Former President Sarkozy unexpectedly lost in the first round of the conservative primaries. A further reason for caution is that markets were also taken by surprise by the victories for both Brexit and Trump, with both subsequently showing intent to implement their more controversial campaign promises.

Mrs Le Pen seeks to break with key principles of the EU through protectionist and nationalist policies. The latter include cutting immigration, withholding free healthcare from illegal immigrants, taxing imports and job contracts for foreign workers, and deporting all foreign convicts. Regarding the Euro, her plan would be first to call an EU summit to replace the Euro with a basket of new national currencies. She wishes to create a multi-currency European zone with countries sharing a virtual unit of accounting for trade, similar to the previous European Currency Unit (ECU). Secondly, she seeks to revoke central bank independence and launch a French version of quantitative easing to finance welfare, industrial strategy, and debt repurchases. Thirdly, she wants the French currency to be initially equivalent to the Euro, with a pledge to limit its fluctuations against the EU currency basket to a maximum of 20%.

A Le Pen victory and a move to a parallel currency regime would involve redenomination risk for €2 trillion government debt, with substantial negative impacts on yields. The 10-year French sovereign bonds (rated Aa2) at a 75 basis point spread above German 10-year Bunds, are now at their widest levels since 2012, off a low of 23 basis points in August 2016.

In addition, a Le Pen win could possibly trigger a broader crisis for both the EU and the Euro. France was a founder member of both political projects, and a Le Pen victory would rupture the vital French-German axis, as well as highlighting populist feelings, which have been growing throughout Europe. The pressure on the Euro would have secondary effects, as a devalued new French Franc would worsen the competiveness of other fragile countries within the Eurozone, such as Italy and Greece.

The most important points for now are that, even if Le Pen wins, she would still need a National Assembly majority in order to hold Eurozone and EU referendums. The probability of achieving this is currently low. Also, even if she does not win, the Italian and Greek situations are worsening, emphasising the ongoing structural challenges faced by the EU and the Eurozone. But with several weeks still to go, we are monitoring the continued shift in momentum towards Le Pen.

Given our expectation of rising political risk in France and elsewhere in coming months, we remain slightly underweight European equities, despite the recently improved economic and earnings forecasts. That said, there could be trading opportunities, nevertheless these are likely to be at the sector and thematic levels. We particularly favour beneficiaries of a weaker Euro, companies with strengthening order books on the back of capital expenditure increases, high dividend yielders, companies with strong cash flows buying back some of their equity and thereby boosting EPS, and companies in the IT space benefitting from exposure to fast-growing areas like robotics and e-commerce.

In addition, should the French political risks not materialise, this could be supportive for French assets as well as more broadly for European assets. This could raise the likelihood of a higher European equity weighting. Besides potential tactical opportunities during the campaign and the election itself, a possible strategic opportunity could present itself if political risk subsequently subsides significantly.