Bond sector showing biggest fears over Le Pen victory in French poll
The first round of the French elections takes centre stage tomorrow and investors around the world will be watching closely. The key concern is whether the far-right and Eurosceptic candidate Marine Le Pen - who has promised to renegotiate France's relationship with the European Union and call a 'Frexit' referendum within six months - will become the next president.
A victory by Le Pen is not altogether improbable. She is running neck-and-neck with Emmanuel Macron, an independent, and the current four-way race opens up several possibilities about who she may face in a second round.
While her polling gap versus Macron is large in the second round, and seems hard to close in just two weeks, Le Pen could have a better shot versus some opponents such as Francois Fillon of the centre-right Republicans and the Communist-backed Jean-Luc Melenchon. But not all investors are equally worried about the outcome. Bond investors are seemingly very concerned about the risk of a Le Pen victory and the tail risk that France exits the EU and adopts a new currency; equity investors are showing more relaxed attitudes.
The simplest way to spot the tension in the fixed-income market is to look at the difference in yields between French and German 10-year bonds, which has widened from 30 basis points in early November to around 70 basis points currently. The spread has clearly correlated with the performance of extremist candidates and is now at the highest since the European debt crisis.
We have also seen this concern expressed in money flow data. Japanese investors sold $15bn of French bonds in February, the largest monthly sale on record as political risks emerged in earnest.
Moreover, pricing of short-dated German bunds, which now have yields much lower than even European money market rates, suggests that redenomination risk is playing a role in investor behaviour.
The spread between older French credit-default swap contracts and newer contracts tells a similar story.
Equity investors seem more relaxed. The CAC 40 Index of French stocks trading close to multi-month highs and investor surveys point to "overweight" positions among institutional investors in European equity markets.
US buying of European stocks through exchange-traded funds has seen some of the strongest flows since 2015 of late. Although the nominal amounts are not huge, at around $2bn (€1.8bn) in recent weeks, they should be viewed as a proxy for broader flows happening outside the ETF space.
Even during the periods of elevated tension caused by French election polling and the rise of far-right and far-left candidates in mid-February and early April, it was hard to see any material weakness in European equity indexes outside some pressure in bank stocks.
So, what is going on? There are at least three narratives to explain the relative resilience of equities.
First, equity investors learned in 2016 not to panic in the face of political risk. That was the lesson both from the experience around the UK Brexit vote and Donald Trump's election victory in the United States. Some equity investors have even concluded that populism may be a bullish force.
Second, equity investors are supposed to be risk-tolerant. After all, owning stocks is about getting paid a risk premium for providing long-term capital.
In contrast, conservative fixed-income investors are looking for risk-free returns, and many developed-market bond managers can't tolerate tail risk, even if it is remote.
This could be a key factor behind the seeming divergence between fixed-income and equities in relation to European political risk.
Third, we observed during the euro crisis that equity markets can be very sensitive to systemic tension.
European funding market stresses repeatedly drove equities sharply lower from 2010 through 2012. But the tension around the French election has been muted. While French government bonds have sold off, there has been little evidence of stress in money markets, perhaps because of the European Central Bank's more liberal attitude towards liquidity provision compared with the pre-long-term refinancing operation, or LTRO, days.
Regardless of the specific reasons, the recent discrepancy between fixed-income and equity market behaviour creates an interesting potential asymmetry as the election unfolds. (The four leading candidates all head into the final hours of campaigning with a chance of qualifying for a run-off on May 7.)
In the market negative scenario, meaning either a Le Pen or Melenchon winning, we could see significant adverse equity market moves, as investors will have to price in bigger risk premiums.
This assumes that the "populism is bullish" argument is not going to dominate in the case of France.
That's likely to be the case eventually as political instability in the very core of the eurozone should create systemic tension in the entire currency bloc, especially if it becomes clear that a Frexit referendum will actually take place. As such, fixed-income markets will hardly be immune in such a scenario. (Bloomberg)