French Election – Bad Dream Intrusion

The “Nightmare Option”

The French presidential election was temporarily relegated to the back-pages following the US strike on Syria, but a few days ago, the Economist Magazine returned to the topic, noting that a potential “nightmare option” has suddenly come into view. In recent months certainty had increased that once the election moved into its second round, it would be plain sailing for whichever establishment candidate Ms. Le Pen was going to face. That certainty has been shaken quite a bit lately.

It seems Mélenchon has taken support from everyone – with the noteworthy exception of the scandal-ridden conservative candidate François Fillon of all people. The latter is slightly gaining in the polls as well, after he decided he wouldn’t let a little corruption scandal get in the way of his presidential ambitions. A chart showing first round voter intentions according to the latest opinion polls illustrates the stunning effect of  Mélenchon’s debate performance:

First Round Voting Intention, Jan 2017 - May 2017

French national opinion polls, average. Mélenchon’s support has taken off like a rocket, and even Fillon has managed to regain some of his past glory. Macron and Le Pen have lost about 2% each since the March debate, while Hamon has essentially suffered a flash-crash - Click to enlarge

With  Mélenchon at 19%, Fillon at 20%, and Macron and Le Pen at 23% each, anything is now possible, as they are all within the known margin of error of French opinion polls. The so-called “nightmare option” would of course consist of Le Pen and  Mélenchon making it to the run-off election. That is still not the most likely outcome, but it has at least become possible.

All it would take is a major misstep by Mr. Macron in the final days before the election. As an aside, he has never been elected to office and his party is just a few months old. It seems at least possible to us that both his and Le Pen’s poll results are distorted by the “Bradley effect” – i.e., by the fact that some voters are not revealing their true intentions in surveys, because they fear they might be seen as violating social acceptability norms.

Recall that this is precisely what happened in the polls trying to gauge voter support for Donald Trump and Hillary Clinton. The lesson is that if one fosters a climate of fear in order to enforce political correctness, one ceases to get truthful replies in voter surveys (the effect is a bit similar to what happens if one attempts to elicit truthful information by means of torture).

France Unemployment Rate, 2008 - 2017

A major reason why French voters are unhappy: unemployment in the country remains stubbornly high - Click to enlarge

We believe not even a match-up between Le Pen and one of the “moderate” candidates in the run-off would be a slam dunk; a week ago, 40% of French voters still said they remained undecided regarding their second round voting intentions and the “Bradley effect” would remain an important consideration.

Mild Market Concerns

A number of financial market indicators reflect these recent developments, but all in all we would term these expressions of concern as rather mild. Here is a chart of the spread between 2 year German and French government note yields – it has certainly increased quite a bit lately, along with Mr. Mélenchon’s poll numbers, but  it is still a far cry from the panic levels seen at the height of the sovereign debt crisis in late 2011. Moreover, the spread doesn’t show that French 2 year note yields remain at minus 33 bps, even though that is up quite a bit from their low of minus 71 bps in late 2016.

France and Germany - 2 Year Bond Yield, 2012 - 2017

The spread between French and German 2-year note yields. Suspicion is evidently no longer asleep, but keep in mind that the French 2 year yield remains at minus 32 basis points in absolute terms (see also bonus chart further below) - Click to enlarge

Euro Yen Risk Reversal, Jun 2015 - April 2017

Prices of one-month calls on EUR vs. JPY relative to prices of puts - Click to enlarge

It is a good bet that any pairing of second-round candidates that is not named Le Pen –  Mélenchon will be greeted with relief in the markets, i.e., a stronger euro, a  rebound in French government debt and a contraction in assorted volatility premiums in European markets. On the other hand, if Le Pen and Mélenchon both make it to the run-off, all hell is likely to break loose in the short term.

Then it will be time to consider to what extent they can impose their agenda in practice, and it seems quite certain that the National Assembly will be able and willing to sabotage them at every turn (Le Pen more so than Mélenchon, but he will also have difficulty finding support for most of his ideas). Trump has it a lot easier, and even he is so far not succeeding in getting legislators to unite behind him.

France CAC 40 Index, May 2016 - 2017

CAC-40 Index – recent weakness has so far only taken a fairly small bite out of it - Click to enlarge

Conclusion – Best not to Make Assumptions

Similar to previous well-telegraphed potential threats to the system’s status quo, the election in France is likely to reward very nimble traders (and those making the correct guesses beforehand), but we would warn against smugly assuming that nothing unexpected can possibly happen. If the pairing of Le Pen and Mélenchon ends up moving on to the second round, the market response will likely be a lot more pronounced than on occasion of the Brexit, since France is the European core nation apart from Germany. It is probably fair to say that there is no EU without France.

The markets will likely be relieved in the short term if either Le Pen or Mélenchon faces Macron in the second round and somewhat more nervous if one of them faces Fillon – who could easily get pole-axed by his still simmering scandal, which is currently under official investigation. We would nevertheless recommend to remain extremely wary if e.g. Le Pen is paired off with Macron, even though surveys indicate that the latter would have a 60:40 lead over her in the run-off.

Establishment golden boy Macron enjoys the support of the media, but he has even less of a political power-base than Le Pen or Mélenchon. With a large percentage of undecided voters, a presumably quite energized political base in the “populist” camps and considering the Bradley effect, fate could well serve up another unexpected curve ball.

When Geert Wilders “lost” by gaining 33% more seats in the Dutch election than in 2012, assorted Eurocrats and the European press were unanimous in asserting that the momentum of populist movements was broken. We are not so sure about that, even though it looked at one point in 2016 as though Wilders would win the election outright.

Dutch Election Outcome, Nov 2016 - April 2017

The Dutch election and the polls preceding it. In late 2016 Wilders’ PVV appeared set to win a majority of the seats in parliament, but in the end it had to make do with 20 seats vs. 15 in 2012 - Click to enlarge

As we noted in Affairs of State, Mr. Erdoğan is a man entirely bereft of humor, possesses the diplomatic tact of a bull in a china shop, and simply cannot stop himself from incessantly farting in church, to stay with the metaphors. His attempts to hold political rallies to advertise a controversial referendum that has just established him as the capo di tutt’i capi of Turkey to his countrymen living in Western Europe were strongly resisted by European governments. The opportunity to do the same probably saved Mr. Rutte, who finally got a chance to let his inner Wilders hang out.

That said, analogous to Wilders, Ms. Le Pen has recently also lost a bit of support (to the extent that the polls can be believed), and if she gets through to the second round, it does seem likely that she will lose regardless of who her opponent is going to be. Insofar the first round is probably the more momentous occasion, given the potential that it will result in a Le Pen –  Mélenchon pairing. Still, what happened to Mr. Rutte – namely that his odds of winning the election vastly improved by means of a timely coincidence – could conceivably also happen in some form to Ms. Le Pen before the run-off election.

France 2 Year Government Note Yield, May 2015 - April 2017

France’s 2-year government note yield – it has recently begun to spike, but remains deeply in negative territory (-33 bps). This is still far from reflecting serious re-denomination fears - Click to enlarge