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The main risks from the French election
Although the reporting season brought few surprises and bond spreads remain tight due to regulation, quantitative easing and the prudence of most market participants (indeed, it is well worth asking whether it is wise to invest at 1.40%, the average BBB yield, for 10 years), it is time for portfolios to be protected against the electoral risks which they face, particularly in France.
After the recent votes (Brexit, Trump, Italian referendum), portfolio managers have become accustomed to seeing negative outcomes with no impact on the markets. But they would do well to beware of the French election as it could be different:
1/ Unlike Brexit, which involved a country which had a specific status and kept a distance from the rest of Europe, or the Italian referendum, which merely validated the institutional continuity of the country, the French election could mean the beginning of the end of Europe and the Eurozone. This would, without a doubt, have consequences for euro-denominated portfolios.
2/ Trump’s protectionism is worrying particularly as the US is the most powerful economy in the world. The country is indeed so powerful that it can afford a fair number of flights of fancy without their having a negative impact on the greenback or borrowing rates.
So, the French election is significantly different from both Brexit and the US elections. As France was one of the founders of the EU, an internal swing towards euro-scepticism would probably call into question the very existence of the Eurozone. And, contrary to the US, France is not a heavyweight, so that if the results of the election triggered strong volatility as well as a significant and lasting loss of investor confidence, the country would be less competitive and lose its international reputation. Moreover, it has the disadvantage of being heavily debt-burdened.
France’s finances stand to suffer from euro-scepticism, on the one hand, and the government’s blatant disregard for prudent budgetary practices, on the other. The political parties in the arena all juggle with these ingredients.
With the election only 2 weeks away, we will attempt to identify possible market reactions to various outcomes so that protective measures can be taken based on the individual operator’s appetite for risk:
Significant euro weakness,
Widening of French government bond spreads with eventual contagion to the peripheral countries,
Widening of bank spreads,
Underperformance of cyclical domestic issuers, and
Lower impact on exporters with low levels of debt, operating in defensive sectors.
 
It may, then, make sense to: (i) hold dollar-denominated investments,(ii) limit holdings of French government bonds to a strict minimum or to hedge them, (iii) sell positions in banks, especially if subordinated, (iv) limit holdings of high yield cyclicals, the most vulnerable in the event of tightening credit conditions, and (v) favour defensive exporters.
 
It is worth pointing out that if an EU-friendly party favouring debt reduction wins the election, the negative effects would surely outweigh any positive impacts, for two reasons:
 
1/ In the credit markets, rates and spreads are already extremely low due to monetary policy and regulatory constraints for investors. They are no reflection of issuer credit quality. The marginal impact of positive news would therefore be diminished (or nullified), whereas the effect of negative news would be immediate and massive.
 
2/ There are numerous precedents. The markets will probably wait to see what happens, who is elected and what the policy is before changing their view on France’s sovereign debt. As to whether the Eurozone and the euro will survive, we believe that if France withdrew, the entire zone would collapse … not that France’s presence ensures its survival, makes it more efficient or any easier to run.
 
If France’s europhiles win the day, sovereign spreads will probably narrow slightly, the euro will climb against the USD and there could be a slight rally before the legislative elections to come a few weeks after the presidential election.
 
 


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