Markets may have seemed less preoccupied with the French elections of late but as the race narrows, with the top four candidates all polling between 18% and 24%, the first round of the Presidential elections is too close to call.
What are the risks if a euro sceptic wins?
Reports by institutional research departments suggest that market operators see around a 20% probability that a Euro sceptic candidate will win the presidency in France. We consider this probability has now edged up to 25%.
While the chances are slim that such a candidate would actually embark on a programme to leave the euro zone, the probability is not zero.
The impact of a pro-Frexit president is hard to evaluate but seems highly likely to trigger a major period of stress across all European markets. Our scenario has the spread between French and German government debt increasing from 65 basis points to 200 basis points, equity markets falling sharply and a slump in the euro.
Should we protect ourselves from “France” risk?
The assumptions can be debated, but the real question is how to limit the scale of any negative impact on the portfolios, while retaining an appropriate asset allocation if the risk fails to materialise.
The answer will obviously vary from portfolio to portfolio, but in most cases we recommend partial protection of risky assets. In fact, since we see current market levels as rather expensive and with little sign of the political risk being priced in (low volatility, low level of hedging, etc.), the risk seems to us asymmetrical to the disadvantage of the investor. This does not mean we believe a euro sceptic will come to power on the second round but merely that today’s markets are not paying us enough to run this extreme risk without taking precautions.
The economic environment remains fundamentally positive
Leaving aside this binary risk, March was notable for some strong economic figures. These seem to confirm an acceleration of overall growth during the first quarter, which has also helped the German short rates we wrote about last month return to less extreme levels in relation to their fundamentals.
March also brought disappointing inflation figures in the euro zone, quashing rumours of early tapering by the ECB. This, coupled with the risk that Mr. Trump may disappoint in implementing his program, was another reason why we have adopted a more defensive stance ahead of the French elections.
Our risk is now concentrated on equities, preferably European, emerging assets (equities and fixed-income) and our bond components remain low in duration on government bonds, although this bias has been reduced since last month.
We will be writing regularly on this issue to keep you abreast of our views on the situation and any changes in the investment strategy for our portfolios. You can find all our investment convictions and our detailed economic scenario in the April edition of Analysis & Strategy.