Sizing up the French election’s fear factor

Isabelle sees bond market concerns about a possible victory by populist Marine Le Pen as overdone.

The French election adds to widespread anxiety about the future of Europe. It comes in the wake of the UK’s Brexit vote, the surprise U.S. election outcome and ahead of elections in the Netherlands and Germany later this year. French bond yields have soared to near five-year highs against German bunds, reflecting worries that the populist far-right candidate Le Pen could win the presidency. See the chart below.

chart-BII-french-german-bonds-v2

Should investors be worried? Our bottom line is that the worst-case outcomes look unlikely in France—and European equities remain one of our favored asset classes globally. Below is a Q&A with Isabelle:

Q: How does the French election system work?

A: The president of France is directly elected by voters. Anyone sponsored by at least 500 elected officials can declare candidacy before a March deadline. If none of the candidates wins a majority in the April 23 first round, the two with the most votes will face off in a second round two weeks later. Political polls indicate that no candidate has a majority and that a runoff is likely. The presidential election will be followed by legislative elections in June, also over two rounds.

Q: Who is running?

A: There are several candidates to watch: Former investment banker Emmanuel Macron is running as an independent on a “change” platform that would favor business-friendly reforms and stronger European integration. Le Pen is running on an anti-euro platform with punchy messaging: “Make France great again; grow again.” Republican Francois Fillon is the favored candidate of France’s right with a Thatcher-inspired platform, but has been dogged by a scandal over employing family members as a parliamentarian. Other contenders include Benoit Hamon, winner of the Socialist primary, and Jean-Luc Melenchon, a Socialist dissident. Both are lagging in voter polls.

Le Pen has been in the lead but is far from a majority. Macron and Fillon are deadlocked as runners-up in the first round. Francois Bayrou, a perennial centrist candidate, recently announced he would not run this time and would instead endorse Macron. Most polls and analysts give Le Pen only a slim chance of winning the presidency in the second round, however, except in the unlikely event that she ends up facing off against the unpopular Hamon.

Q: What kind of election outcome are markets pricing in?

A: French government bonds are reflecting the most anxiety over a potential Le Pen win, with the extra yield investors demand over 10-year German bunds widening to the highest level since 2012. We could see the spread widening out to more than two percentage points in the unlikely event of a Le Pen win, but falling back to 0.4% if she fails. European equity markets are showing more resilience—and given our view that political risks are likely overstated—we see more upside as global reflation and signs of stronger European growth give a much-needed boost to corporate earnings.

Q: What if the polls are wrong and Le Pen wins?

To be sure, many polls and markets were wrong on the Brexit vote and the U.S. election outcome. Le Pen’s campaign says that right now “she is unbeatable,” and a surprise victory can’t be ruled out. Yet even if Le Pen were to beat the odds, nobody expects her to gain a majority in parliament. This means she would have a hard time forming an alliance to support a referendum on France’s European Union membership. No other French party supports exiting the euro.

Q: What would Macron do if he won?

A: Macron’s economic philosophy is pretty reassuring to investors. He believes it is important to regain fiscal credibility with Germany and supports labor reforms that would make it easier to hire and fire employees. Macron plans to come out with a “social contract” of several reform initiatives in early March, and will insist all candidates running under his banner commit to supporting these core positions.

Q: If Fillon prevails, what can be expected of him?

A: He favors a rightist program of social spending cuts and an immigration crackdown that may make it hard for him to attract a legislative majority. It will be especially difficult if his victory owes a lot to anti-Le Pen votes from the left and center-left.

Isabelle Mateos y Lago is BlackRock’s Chief Multi-Asset Strategist. She is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

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