Ahead of French elections: Credit Suisse Risk Barometer indicates markets remain unphased by politics Mittwoch, 12. April 2017 - 10:00

As financial markets have focused on positive economic surprises and earnings numbers from companies, Europe has continued to steadily move through a busy electoral calendar which will shortly peak with the French elections. Moving toward the event we have updated the Risk Barometer to gauge ongoing investor risk appetite and outline our thoughts and scenarios for the upcoming French presidential elections. We remain cautiously constructive on European assets driven by the strength of the business cycle. The euro remains relatively weak and further depreciation is expected.
 

The French presidential election will be held amid a favorable cyclical backdrop. Sentiment indicators for both manufacturing and services have improved rapidly, and reached their highest levels in almost six years. Buoyant consumer sentiment has fed into private consumption, fueling a virtuous cycle of falling unemployment rates and further increases in spending. Despite the favorable near-term growth outlook, the new president will be confronted with the same structural problems that have haunted the French economy in recent decades: a lack of competitiveness, an inflexible labour market and high public sector spending. The candidates are well aware of the issues, and have addressed them to various degrees in their agendas, however, policy initiatives would have to overcome potential opposition from parliament and from “the street”. A strong popular mandate will thus be crucial. 

Risk barometer indicates risk appetite was undiminished in March

The updated Barometer continues to indicate a market-wide absence of concerns about systemic risk but we expect risk appetite to diminish if the second round sees a close run race between Marine Le Pen and another candidate. Looking across sectors from money markets and fixed income to equities and currencies we find that relative to recent history the market is currently scoring approximately 2 (on a scale of 0 to 10 where 10 means valuations reflect deep investor concerns about future risk). The Barometer, designed to gauge the level of risk priced into capital markets, is based on a spectrum of risk based on 10 years of data which includes the Lehman default, Greek crisis, Brexit and Italian Referendum.

In government bond markets, declining concern about risk has been notable in falling short- and mediumterm sovereign spreads on Italy and Spain versus Germany. Market liquidity has remained robust and low bid-ask spreads have also kept trading costs low. In credit markets, easier financial conditions were observable in lower consumer and small corporate loan rates, whilst both investment grade and high yield bond spreads declined. Equity valuations were marginally higher in March as reflected in Price/Earnings multiples on EMU equities, whilst separately in a reversal from the previous trend a stronger EUR/USD was also symptomatic of less concern about the Eurozone. Expectations of higher  volatility are centred on the weeks directly linked to the French elections otherwise remaining at a low overall level.

Positive economic and earnings momentum to drive Eurozone equities to outperform

Our Investment Committee recently moved Eurozone equities to outperform. Leading indicators in Europe have risen to a 5-year high, profitability is on the rise and relative earnings revisions are strong for European companies compared to global equities. Both domestic and export-oriented companies benefit from tailwinds as macroeconomic momentum in the Eurozone is at a multi-year high, while the EUR is relatively weak and our expectations are for a further depreciation. While the broad fundamental picture is constructive and valuations are appealing, political risks cannot be ignored, which is why we nevertheless have an underperform view on Italian equities as the event risk posed by the French elections could still be most keenly felt in the periphery. 

Three scenarios for France

To assess the potential outcomes for markets of the French elections we have defined three scenarios: the first scenario, with a probability of 15% results from Marine Le Pen not reaching the second round of the election. Risky assets and French stocks in particular would benefit as well as would those that benefit from the removal of periphery risk. We assign a 65% probability to our second and central scenario. In this outcome we expect volatility to temporarily increase between the two rounds driven by sensitivity to the gap in the polls between Marine Le Pen and an opposing candidate and reflecting concerns about domestic and regional policy uncertainty. The third and final scenario, which we see having a probability of 20%, sees Marine Le Pen win the French presidential election and a risk-off environment prevail in markets as investors discount far-reaching consequences for Europe. This is based on the potential renegotiation of EU treaties and a return to a national currency, items at the heart of her party’s program. 

Uncertainty and volatility should give way to European integration and reform

This election remains the most unpredictable contest we have seen over the past years in France. The primaries of the Republican and Socialist Parties already led to the selection of less well-known figures, François Fillon and Benoît Hamon. Since then, the campaign has been dominated by scandals and fragmentation within the mainstream parties. There is a risk the two candidates from the main parties will be eliminated in the first round and the scandals have also led to lower general public interest in the contest. Currently 35% of French voters are considering staying at home for the first round according to surveys, an unusually high number given historical turnout has always been high, averaging approximately 80%. Finally, of those certain to vote a large share could still change their minds at the last minute, which contributes to making the race volatile. 

While acknowledging these risk factors, our central scenario is that a pro-European, pro-reform candidate will likely win the race, which would be well received by financial markets as being positive for European integration and peripheral countries. We expect political risk in southern EMU countries to decline in this case. 

On the horizon are elections in Germany and Italy

Elections in Germany in September are likely to be closely contested between Angela Merkel of the Christian Democratic Union and the revitalised Social Democratic Party led by Martin Schulz. Whilst either outcome would not appear to be a potential source of volatility in markets, the importance of the election should not be underestimated given the need for strong leadership in Europe at a time of Brexit negotiations, the need for EU reform after Brexit and in light of the demanding context of geopolitics between the global superpowers including the EU, US, China and Russia. 

Separately in Italy the market outcome of the December referendum might have been benign following Mr Renzi's resignation in February, but the government formed by Paolo Gentiloni remains vulnerable to the political manoeuvrings within the divided party and wider coalition. A new leadership election is due to take place on April 30th  and albeit elections before 2018 now look less likely, opinion polls after the event will be watched closely for changes in voting intentions between the Partito Democratico and Five Star Movements. The two parties are currently tied in the polls. These events continue to be significant because Italy represents the key long-term risk in Europe and since Five Star also represents the strongest anti-establishment movement in the region.