Fears of a French catastrophe may be overblown

The Netherlands, France and Germany all go to the polls this year – in that order – but the middle election most preoccupies those in Brussels. What, Europe’s bureaucrats fret, will happen if France picks Marine Le Pen, the leader of the right wing National Front, as its next president?

“The decline in popularity of [centrist candidate Francois] Fillon has increased the risks of a Le Pen victory,” said Steve Brice, chief investment strategist at Standard Chartered Private Bank in Singapore.

A victory for Le Pen, who is campaigning on the promise to leave the eurozone, could be disastrous for the EU. The possibility has investors jittery, to judge by Bank of America Merrill Lynch’s most recent monthly fund manager survey.

All told, 36% of respondents in February cited European disintegration as their biggest tail risk, which the survey defined as an event that would move assets more than three standard deviations below current prices.

Yet despite these worries, investors continue to back the region’s stocks. European funds posted a net $606 million inflow in the year to February 20, according to data provider EPFR.

Market paradox

Why are investors running to build exposure to the potential political calamity that so many of them fear?

Help in unravelling this paradox is provided by a recent paper by Pim Lausberg and Eran Raviv called ‘Interpreting signals from the global economy and financial markets’.

The pair works for Dutch pension fund manager APG and seeks to explain why greater political uncertainty in Europe hasn’t led to higher risk premiums for assets.

It compares the Vix index, which measures volatility, with the Global Policy Uncertainty (GPU) index, which measures political uncertainty. Between 1998 and 2012 the two measures posted high correlation, which seems sensible: when political uncertainty is high, so is investors’ perception of risk.

But the two measures began diverging in 2012, and today the gap is almost as wide as it has ever been. The reason for the divergence, says the report, is that global economic growth has gathered momentum since 2012 despite periods of political upheaval.

“As the global economy remains resilient and political uncertainty has not had real effects, markets do not price in higher political risk,” wrote Lausberg and Raviv.

Brexit outcome

Alan Higgins, chief investment officer at UK private bank Coutts, agreed that economic growth trumps political risk. The continued rise of UK equities following the Brexit vote demonstrates why investors should not being dazzled by the immediate politics, he said.

Investors initially panicked after the surprise vote to leave the EU, with the FTSE 100 plunging 5.6% in the two working days following the June 23 vote. But they soon made it clear they felt the benefits of a weak pound to UK exporters eclipsed the longer-term dangers of life outside the EU. The FTSE 100 has since risen 14.8% to close at 7,274.83 on Tuesday, even as political risk has morphed into reality.

“Macro beats politics; those who invest primarily for politics are playing a difficult game,” said London-based Higgins.

Of course, investors may be wrong. A hard Brexit could be damaging for the UK economy over the longer term, just as a Le Pen victory could potentially spark disaster for the EU. But the short-term lesson is that political upheaval does not necessarily equal financial collapse.

What does this mean when it comes to France and the EU? If you are worried about Le Pen winning the Elysée Palace and the European project imploding, argued Higgins, you should be wary of shorting French equities and going long German equities. This has become a crowded trade.

More importantly, it may backfire: if the euro collapses, a devaluation of the franc could reward French exporters, while a corresponding appreciation of the Deutschmark could hobble German ones. Higgins believes that a more sensible place for bears to hide is on the short side of French bonds, as they would not benefit from devaluation and are starting to build in a chunky premium in terms of yields.

Brice, meanwhile, emphasises another reason not to be dazzled by the politics. He believes both the risk – and the consequences – of a victory for Le Pen victory are over-stated. Even if she were to win, the opposition party looks more likely to win the parliament, which would constrain her anti-euro sentiments.

“We see any significant weakness in global and euro area equities markets as a good buying opportunity in an increasingly reflationary environment,” Brice said.

A Le Pen victory might just signal a timely moment to ramp up stock exposure.