The French election is the major upcoming political risk in Europe. The markets are concerned about a possible Marine Le Pen victory as one of her key campaign promises is to hold a referendum on France exiting the euro currency bloc. The departure of one of the Eurozone’s leading countries would most likely lead to the breakdown of the Eurozone. The instability created by Brexit as well as anti EU rhetoric from Trump and others exacerbates the probability of a Frexit.
Since the end of 2009, the Eurozone has undergone periodic economic crises. Initial cracks in the economic well being of the region first appeared post the 2008 global financial crisis, when concerns arose about the ability of the peripheral countries to meet their debt payments, notably Greece, Spain, Portugal, Italy and Ireland. Marine Le Pen’s victory would undoubtedly lead to a deep political and economic crisis in the Eurozone.
Investors head into this current event with some concerns: What are the odds for this tail risk to materialise? Does Marine Le Pen’s victory mean “Frexit”? How has the volatility of the French OAT yields and their correlation with the other members of the Eurozone evolved since the Eurozone crisis?
There are five candidates for the presidency: Marine Le Pen (Eurosceptic and anti-immigration), Francois Fillon (Center-right), Emmanuel Macron (Center), Benoit Hamon (Socialist) and Jean-Luc Melenchon (Socialist). The first round of the election is the 23rd of April and if no candidate gets above 50% of the vote, there is a second round two weeks later between the top two candidates.
In the last few months, three events could have increased the probability of Le Pen‘s victory:
None of these events ended up happening, and the first round debate last week was dominated by Macron, so the market now expects Le Pen and Macron to win the first round the 23rd of April, and Macron to win the second round which is happening the 7th of May. On the back of this, the market has been reducing their risk hedges. In most polls Macron leads Le Pen by 20% in the second round, which seems like a big gap to close one month before the elections. However, the ramifications of a Le Pen victory are so significant that it is worth taking it seriously.
Are correlations telling us anything?
Correlations so far are telling a tale of a gradual deterioration of the French fiscal picture – France shifting from “core” to “semi-core” – rather than of a risk of a Eurozone break-up.
Before the Eurozone crisis, the correlation matrix showed us that all spreads across the Eurozone were moving together, as a bloc. During the Eurozone crisis, looking at Q4 2011, we can see a clear demarcation between the peripheral countries, and the “core” countries. France, a “core” country at the time was very highly correlated with Germany, and lowly correlated with the peripheral countries.
In recent months we have seen that the correlation between the Bunds and the OAT has decreased substantially (from 0.92 during the crisis to 0.59 now), and the correlation between France and the peripheral countries has increased substantially. The dynamic shows that the market considers the current situation for France to be similar to the situation faced by the peripheral countries in the event of a Le Pen victory.
In the near future, no matter the outcome of the elections, it seems unlikely that France trades again like a core country, given that the election has brought renewed focus on issues the country faces, such as its big deficit and its need for reforms first.
What if Le Pen wins? Does it mean Frexit?
There are two main scenarios if Le Pen wins:
What does Frexit mean?
Frexit would create balance sheet stress and solvency challenges. Under the tail scenario, there would be a FX redenomination and a new yield curve which would likely lead to higher yields in French bonds. This is a big risk given the fiscal deficit in France.
European investors will face two main risks:
This is a tail scenario which remains a very unlikely event, but it has important ramifications so it should not be overlooked. It would be too complacent to think that in the case of a Marine Le Pen win in the presidential elections, parliament would completely stand against the Front National’s willingness to leave the Eurozone. The signal sent by the French people would indeed be very strong and rules and laws can always be changed or circumvented. There would be “sword of Damocles” above the Eurozone, its institutions, and all European assets. As we have seen in previous elections, outcomes that start off as unthinkable, and then appear unlikely, can go on to become reality.
J.P. Morgan Asset Management does not predict outcomes of any political events, nor do we voice firm-wide opinions on any political candidates.