French and German Elections

While 2016 was a massive year for elections, with the American and U.K. populist movements headlining the votes, 2017 will also be a pivotal year. There will be a government transition in China in the fall. There will also be French and German elections which will likely bring equity volatility due to the uncertainty about the results. These elections also have heightened tail risks. However, I don’t see the EU being broken up because of these elections. While I think the EU breaking up is inevitable in the long term, I no longer see it acting as a catalyst for an unwind of this cycle because I think economic uncertainty would be the only way to spur a breakup. If the economic uncertainty spurred a breakup of the EU, it would have already caused the cycle to head downwards.

Anti-globalist sentiment ran supreme in 2016 and it only led to minor corrections in the stock market. Since anti-globalist politicians will lose in France and Germany in 2017, I don’t see political instability being the catalyst for a market crash. However, the higher the market goes, the smaller the catalyst necessary to drive it lower.

First, I will discuss the French presidential election. The first round is on April 23rd and the run-off is on May 7th. The run-off is between the top 2 candidates from the first round. The reason why this election is getting more attention than usual is because populist Marine Le Pen is running. She represents the tail risk which is now being priced into the market. The way we measure tail risk is by comparing the bond yields of French and German bonds. Since German bonds are the gold standard in terms of safety, the premium the French government has to pay compared to the German government represents the risk associated with the election.

The  recent launch of the Marine Le Pen candidacy has spurred a heightened risk premium, as you can see in the chart below. It is at the highest point since the beginning of 2014. Another way to look at bond prices is to measure French bond’s correlation with German and Italian bonds. In the past 60 days, the 10-year French bond is more correlated with Italian bonds than German bonds. Italian bonds are of lower quality than German bonds. In other words, France has gotten riskier due to this election. The last time correlation with Italian bonds was higher than with German bonds was 2012 during the Grexit crisis.

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Marine Le Pen adopts some of Trump’s anti-globalist policies combined with left-wing economic policies. The parts of her platform on the National Front party which are causing volatility are the ones which she has in common with President Trump. She wants France to exit NATO and she wants France to have a referendum on being in the EU within 6 months. If she were to win, the referendum would likely have France leaving the EU. She has all the negatives Trump has without any of the pro-business stances he has. She’s running against laissez-faire capitalism. While the volatility after the Trump election was short lived, if she were to win, there would be a global crash in equity prices which wouldn’t recover immediately.

Some investors who are anticipating Marine Le Pen winning the French presidency don’t understand how the process works. Marine Le Pen is winning in the first round of polls, but is losing in all the run-off polls by a wide margin. In the last poll, which includes all the candidates, Le Pen is winning with 26% of the vote. The second-place contender who would be her challenger, Emmanuel Macron gets 21% of the vote. However, in the head to head match-up she loses by 28 points in the last poll. The closest she’s come to Macron is trailing by 22 points. Some may make comparisons to how Trump beat the odds, but there were a few polls which had him leading during the campaign. According to Opinionway, Macron has a 66% chance of making it to the run-off vote. He is a centrist ex-banker. The immediate reaction to Macron wining would be an equity market rally and a euro rally. I don’t expect Macron to change the trajectory of the French economy in a meaningful way.

The German election is on September 24th. The election for chancellor is determined by the people voting for the parties. The chart below shows the latest average polling. The black line represents the center-right party led by Ms. Merkel who has been the chancellor for 12 years. The SPD is the center-left Social Democratic party led by Mr. Schultz. There has been a media frenzy surrounding the latest poll which puts Mr. Schultz in the lead by 1 point. This isn’t to say he will win, by any means, but it does mean Ms. Merkel will face stiff competition to extend her reign for another four years.

germanpolls

Merkel may be losing support because of her controversial open border policy which has led to refugees threatening the safety of citizens. The big difference between this election and the past few I have covered is that the challenger isn’t a populist. Mr. Schultz is hugely in favor of the European Union, which means if he wins, there won’t be a large spike in volatility. Schultz winning would still be significant because it represents a change in leadership in the largest economy in Europe. He would need to put together a coalition government. One possibility is if the Social Democrats combine with the Green and Linke parties to form a left-leaning government. This would imply increased government spending and greater investments.

Conclusion

            If you are bullish on stocks overall and the euro, you will be pleased by how the elections look to be turning out. In Germany, there won’t be an extreme shift no matter who wins the election. After Merkel or Schultz win the chancellorship, I expect European stocks and the currency to rally. In France, I expect a similar result unless Marine Le Pen finds a way to make up a 20-point deficit in the polls. It is not impossible, but it’s also implausible.

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