It's Macron vs Le Pen: French Election Watch

Co-written with my colleague, Dean Turner, CIO Economist

• The polling booths have closed on the first round of the French presidential election. Exit polls show that this contest has been won by Emmanuel Macron, running on the En Marche! platform. Front National's Marine Le Pen came in second and will be facing Macron in the second round.
• Based on opinion polls, Macron is the favorite to win on 7 May, which may lead to a modest rise in risk appetite, but Le Pen remaining in the contest will likely keep markets on edge. The ECB is expected to stay on hold on Thursday, and will wait for the conclusion of the run-off or later before deciding on QE tapering.
• We continue to monitor opinion polls, the campaign trail, and gauges of market anxiety via sovereign bonds and currencies.

Our view

Exit polls, historically a reliable indicator in French presidential elections, show that Emmanuel Macron came first in this closely fought contest with an estimated 23-24% of the vote. Marine Le Pen came in second (estimated 21-23% of the vote) and will be facing Macron in the second vote on 7 May (fig. 1).

In our view, Macron, running on a broadly centrist platform, is likely to attract voters from both left and right of the political spectrum which should enable him to secure a large majority on 7 May and win the presidency. Indeed, opinion polls in the run-up to the first round suggest that Le Pen would have to overturn an over 25 point deficit to win (fig 2). With this in mind, we are reducing our probability of a Le Pen victory to 25%.

Attention will now turn to the finer points of the candidate's elections pledges, in particular their economic programs, relationships with Europe, and attitudes toward the single currency.

If the final count confirms the exit poll, we expect that markets will welcome the news given the commanding lead that Macron has in the opinion polls for the second round. This could lead to a modest recovery in risk appetite, but we expect investors will remain aware of the risks that Le Pen could still win. Her protectionist, anti-EU views exemplified by her calls for France to quit the euro will continue to be a cause for concern.

Within our Eurozone equity country strategy, we have a neutral rating on the French stock market while political uncertainty remains elevated. We maintain our preference for the euro versus the US dollar which will likely benefit if Macron becomes president of France.

Base case - Macron is the next French president

Throughout the campaign, opinion polls have consistently shown that Macron holds a sizable lead over Le Pen in the event of a second round run off between the two (fig 2). Previously in French elections, the two-round electoral system has seen the anti-FN vote consolidate behind one candidate which has prevented them from gaining office. The most recent example of this was seen in the regional elections of December 2015. Back then, despite FN leading in the first round in six of the 12 regions, they didn't win any in the second ballot. In our view, we are likely to see a repeat of this on 7 May, with the anti-FN pro-European voters seeing Macron as an acceptable candidate to support. Thus, Emmanuel Macron is most likely to be the next president of France.

Le Pen could still be the next president

To be sure, there is a sizable chance that Le Pen could turnaround her deficit in the polls. FN will now likely position the campaign as the nationalists who support the French people (Le Pen) against the global elitists (Macron). How well this strategy plays out in heartlands of rural France will be crucial to her eventual success. But beyond the finer details of the economic and social program other factors could still swing the vote in her favor. The first is voter turnout, which if low, is expected to increase her chances of winning. Given Macron is widely perceived as a liberal, establishment figure, this could become a consideration if either older conservative voters or left-wing voters decide they cannot support him.

Another factor is security. Le Pen has won support through her campaign with a pledge to clamp down on immigration in order to prevent terrorist attacks. If another tragic event happened before the second round, it could boost her chances further.

The Achilles heel for Le Pen's campaign is widely regarded as her anti-EU stance and desire to quit the euro - Frexit. If she were to soften her tone here, on the basis that opinion polls suggest the majority of French citizens support remaining in the single currency, this could further raise her chances of winning.

Taken altogether, we think that the chances of Le Pen winning the presidency are around 25%

The economy, Frexit, and the EU

Under our base case of a Macron presidency, we believe that the steady implementation of his economic program which aims to lift growth by focusing on reforms to the labor market, taxation, and the public sector, will enable the economy to continue on its current growth path. Furthermore, his constructive and collaborative attitudes towards to Europe could mean progress is made here (Table 1).

The alternative, a Le Pen presidency, is likely to deliver a very different outcome. The protectionist, anti-EU program is likely to hit the economy in a negative way. Moreover, it is likely to be felt relatively swiftly especially if borrowing costs were to rise in response to market concerns about Frexit.

As for Frexit, clearly this will only be a consideration if Le Pen becomes president. But even then we believe the probability of such an outcome is rather low. First, there is no guarantee that Le Pen will hold a referendum; she has stated she will look to renegotiate with the EU at first. If an amicable compromise cannot be reached she would then look to hold a referendum. Second, the political and constitutional hurdles against holding a referendum on euro membership are extremely high and would require the support of parliament which Le Pen is unlikely to have (see below). However, it is not inconceivable that if a French president wanted to hold a referendum on the subject without the support of parliament they could. So, third, even if a plebiscite were to be held, public support for the single currency remains high (estimated at 60-70% by opinion polls) so the French public are unlikely to support such a motion.

Weighing all of this up leads us to conclude that if Le Pen were to become president, the risks of Frexit are relatively low, something that we would subjectively assign a 10-20% probability to.

Look towards the parliamentary elections

Once the 7 May result is known attention will soon turn toward the assembly elections that take place on 11 and 18 June. The outcome of these elections is key for either candidate as they will need the support of parliament to implement their economic program. Polling data for these elections is currently scarce, but it seems unlikely that either candidate's party will gain a majority of seats, which would mean that the president would be in what the French call "cohabitation" with the Assembly.

This is perhaps more relevant for Le Pen, especially if she does wish to pursue a referendum on the euro, as it will likely prove to be a significant hurdle for her.

As for Macron, given his centrist position and his background in the previous government it is likely that he could achieve cross party support for a significant part of his agenda. A grand coalition arrangement is not inconceivable. However, investors should be alert to risks that some of his ambitions are frustrated by the Assembly, as has been the case for presidents in the past.

ECB to stay on hold on Thursday

Economic data in the Eurozone has been solid so far this year. Real activity data is pointing to growth somewhat above potential. However, business surveys such as the PMIs suggest upside. On the inflation front, we expect the decline in inflation from 2.0% to 1.5% in March to reverse at least partially this month as calendar distortions from the timing of Easter unwind. Accordingly, the balance of risks has shifted for the ECB.

However, given the continued possibility of a Le Pen presidency in France, we think that the Governing Council will remain on hold on Thursday. We continue to expect the ECB to adjust its forward guidance in June/July, as we don't see the UK elections on 8 June 2017 as a downside risk for the ECB.

In September, the ECB should then announce its plans to wind down QE starting in January 2018. The announcement is expected on 7 September 2017, in time before the German elections on 24 September 2017 (QE is unpopular in Germany). We don't expect the Italian elections in early 2018 to hold the ECB back from winding down QE during 2018 (over six-nine months), while interest rate hikes are expected in 2019 at the earliest.

Meanwhile, a Le Pen win would most likely increase risks to our view of the ECB tapering its quantitative easing program in 2018.

Market implications

Bonds: With the tail risk of euro exit remaining in place, we expect an additional risk premium on bonds of French issuers versus their peers to persist during the run-up to the second round. We think a Macron presidency would be perceived positively by credit markets. On the contrary, a Le Pen victory would likely weigh on French bonds overall, in particular on bonds issued under French law, which would be most at risk of currency redenomination in case France were to leave the euro.

Equities: The result of Emmanuel Macron facing Marine Le Pen in the second round of the French presidential election should be welcomed by the Eurozone equity markets in general and the French market in particular, given the lowered chance of Le Pen winning the presidency. The prospect of a Macron presidency should provide market support because of his pro-growth economic program, focusing on labor market reforms, lowering corporate taxes, and gradually reducing the government budget deficit.

The upside for French equities relative to the wider Eurozone is likely to be limited ahead of the parliamentary elections to be held on 11 and 18 June. Both candidates will need the support from the French parliament to implement their economic program, but at this stage it looks highly unlikely that either candidate’s party will win a majority of seats.

At the sector level, Eurozone banks in general and French banks in particular should be among the major beneficiaries of the first round result. French banks have underperformed MSCI EMU and MSCI EMU Banks by 5-6% year-to-date, partly as a result of political uncertainty. We are overweight financials in our Eurozone sector allocation. At a country level, the French equity market has only slightly underperformed MSCI EMU year-to-date. We have a neutral recommendation on French shares within our Eurozone equity country strategy.

A Le Pen victory, to which we assign a 25% probability, would likely rattle European equity markets, given her attitude toward EU membership. Regardless of the legal complexities involved in holding a referendum and the small likelihood of the public voting to exit the Eurozone, investors will probably worry that a Le Pen presidency would trigger an existential crisis for the EU and the euro.

FX: With equity markets cheering and investors gaining confidence in French government bonds we expect also the euro to rise. Between now and the final outcome on 7 May the upside for the euro is probably limited with stronger forces unleashing once it should be crystal clear that Marine Le Pen will not make it into the élysée Palace. We expect EURUSD and EURCHF to stabilize in a rough 1.08 to 1.10 range until that happens and eventually break higher towards 1.12. Option-implied volatilities for EURUSD and EURCHF are likely to break significantly lower. Before the elections EURUSD volatility was above 12%; a return to 7% is likely in that case. The first round of French elections supports our view that the Euro enters an appreciation trend versus the US dollar. Should Le Pen actually win the second round, EURUSD and EURCHF are likely to fall towards parity before stabilizing. US authorities, the ECB and the Swiss National Bank can be expected to calm down markets in order to prevent a larger meltdown of the euro.

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