Are French Politics Trumpeting Concerning Change?

All right folks, we interrupt your regularly scheduled media dissection of US politics with a bulletin from overseas: French politics are now rattling investors, too. With the presidential election about two months away, the far-right Front National's (FN) Marine Le Pen currently leads polls while pro-euro candidates are in disarray. Her vow to take France out of the eurozone has sparked some nervousness now showing up in bond yields. The gap between 10-year French and German yields has soared in recent days, leading many to fear trouble awaits. Yet it's fairly normal for volatility to escalate in the run-up to a widely discussed event like this-particularly one that, like the French election, fosters uncertainty. It isn't a sign of definite approaching trouble. Often, it means stocks have more wall of worry to climb.

As Brexit and Trump taught the world, polls aren't infallible. Le Pen currently leads a field of 10 candidates, which probably gets her through the first round on April 23, but it doesn't guarantee her the presidency. If no candidate secures 50% of the vote, the top two finishers have a decisive run-off on May 7. This is where Le Pen-whose 144 presidential commitments include leaving the euro and holding a referendum to Frexit^[i] the EU-likely hits trouble.

In local elections last year, many FN candidates sailed through round 1 as the opposition split the vote. In round 2, however, the mainstream Socialists (center-left) and Republicans (center-right) joined forces, and the FN didn't win a single regional government. Chances are high something similar happens this time, even though Le Pen's challengers seem disjointed. The Socialists nominated leftist Benoît Hamon, who isn't expected to contend. Republican candidate FranÇois Fillon, a former prime minister and the early favorite, is mired in a scandal over employing his wife when he was a lawmaker. With Fillon doing damage control, independent centrist Emmanuel Macron has picked up support, but many worry his popularity is peaking too early and that the lack of a strong party apparatus behind him will hurt.

Yet last year's local elections suggest this isn't such a risk. The Socialists and Republicans threw their collective might behind each other's candidates, turning out supporters in droves to keep the FN out of power. It's highly likely whichever candidate faces LePen in round two will have similar machinery behind him. And for what it's worth, the latest polls give both Fillon and Macron a strong edge over Le Pen in a head-to-head race. Obviously that can swing wildly as the campaign evolves, but this also means investors have time to get the lay of the land and measure the probability that Le Pen a) wins and b) also gets enough Parliamentary support in June to get anything done. Even if the FN gains a plurality of seats, they'll probably end up sitting in opposition, much like the Swiss People's Party, while a weak coalition of the center-left and center-right run the government. Markets move on probabilities, not possibilities, and the probability that Le Pen can take France out of the euro or EU remains quite distant for now.

While French bond yields are jittery, hitting a 17-month high on Monday after Le Pen's formal presidential campaign launch, such wobbles are fairly normal, and they've already eased back a bit. Bond markets, like stocks, are subject to investors' emotional whims in the short term. Yet some say these aren't your typical temporary jitters because German bund yields fell, causing a spike in the spread. (Exhibit 1)

Exhibit 1: French-German 10-Year Bond Yield Spread

Source: FactSet, as of 2/7/2017.

Spanish, Portuguese and Italian 10-year yields also ticked up, which some interpreted as a sign investors seek the safety of German debt, worried about ripple effects from an increasingly probable Frexit. Because markets look ahead, some folks argue this presages trouble.

However, history suggests otherwise. Yes, markets are forward-looking and price in well-known events before they happen. However, it is also quite normal for volatility to surge before said events regardless of the outcome, as uncertainty rears its ugly head and causes some bumpiness. Most recently, this happened before last year's Brexit vote and Italian referendum. In both cases, yields spiked in the run-up, then relaxed as uncertainty fell.

Exhibit 2: UK 10-Year Gilt Yields in Lead-up to Brexit

Source: FactSet, as of 2/7/2017. 10-Year UK Gilt yield, from 12/31/2015 - 12/31/2016.

Exhibit 3: Italian 10-Year Debt Yields in Lead-up to December Referendum

Source: FactSet, as of 2/7/2017. 10-Year Italian debt yield, from 12/31/2015 - 12/31/2016.

Neither of these well-known political events (and others like them) caused immediate market disaster. They did, however, create some uncertainty, which often weighs on markets in the short term, especially when headlines constantly warn "it's different this time." It's fear of the unknown. After the vote, the unknowns mostly disappear. Regardless of the outcome, investors and businesses at least know what they're dealing with. They can get on with life and resume taking risks. UK business investment, for example, is up post-Brexit. So are UK stocks. We expect something similar in France. Much as falling political uncertainty boosted sentiment in the UK and US last year, so should it give Europe a tailwind this year as political events come and go. March's Dutch election, the French contest and Germany's vote in September are all opportunities for uncertainty to drop.

Moreover, despite that little bund-spread spike, France's markets aren't flashing huge warning signs. For one, French debt yields are still negative^[ii] up to five-year maturities. If markets truly expected something awful, why would investors pay to own French debt for the next president's entire first term? As for the uptick in long rates, we take a more positive view. Rising long rates steepen the yield curve, giving banks more incentive to lend-a tailwind for growth. France's yield spread is now 79 basis points wider than it was on September 30.^[iii]

As for FN fears, we aren't Pollyanna about them. If Le Pen wins le presidency and the FN surprises in parliamentary elections this summer, this raises the risk France leaves the euro and broader EU, which would probably be a negative if it actually happened. However, as an investor, you must look at what's probable, not possible.^[iv] Again, the odds are heavily stacked against a gridlock-busting Le Pen government. While she likes to point to Brexit and Trump as precedents for her, both the "Leave" campaign and the current US President polled much better than Le Pen ever has. (Again, take polls with a grain of salt.)

While we are monitoring the situation, always remember politics are just one market driver. Economics and sentiment matter, too, and the eurozone overall has been doing much better than most fathom. As this election and others pass, the resulting falling uncertainty should help folks see a stronger-than-appreciated eurozone, leaving lots of room for bullish upside surprise.