The French Elections

Craig Sullivan, CFA, CAIA®, Director of Fixed Income, April 2017

The decision of the United Kingdom to exit the European Union (EU), the victory of Donald Trump in the U.S. presidential election, and the result of the Italian referendum last year opened investor’s eyes to the rise of populism around the world. In Europe in particular, the established political order is under pressure from parties who stray from the political center in response to popular discontent. Much of this displeasure has grown due to previously sophisticated economies growing at below average long-term rates since the global financial crisis in 2008. This has resulted in high levels of unemployment and a decline in living standards in many parts of Europe, and given rise to Anti- European Union and/or Anti-Euro currency populist parties. In the European Parliament elections in 2014, populist parties scored large gains, and there is growing concern about a populist, anti-Euro, party coming to power in a large European country. With sovereignty and power still residing mostly with member states themselves, a populist party coming to power could fundamentally change Europe, potentially endangering the integrity of the EU and / or the Euro currency in the process.

The next major event in Europe is the French election, which is currently taking center stage in the minds of investors and in the media. Since the financial crisis, France has struggled with high unemployment, which stands at approximately 10% and is eighth highest among the 28 EU member states. One in four French citizens under-25 are currently unemployed. However, France is also struggling with an unprecedented national security threat and a steady stream of largely unwanted migrants.

The French elections have been billed as make or break for the EU and the Euro. Gerard Araud, the French ambassador to the United States, recently wrote, “That’ll be the real significance of the French elections: the survival or the demise of the EU.” The current President, Francois Hollande, is not seeking a second term – the first French president to not seek a second term in modern history. The first round vote for the French presidential election will be held on the 23rd April. Absent a landslide 50% absolute majority for one of the candidates, the two candidates with the highest vote share will go into the decisive second round of the election, held on 7th May.

However, one of the most underappreciated facts about France is that there is a second election also taking place this year on June 11th and June 18th for the National Assembly. Similar to the Presidential election, the electoral system for the 577-seat National Assembly can also potentially have two rounds. In the first round, if a candidate gets to over 50% of the vote, and at least 25% of all registered voters, then he/she wins the single-member constituency. If not, then a second vote is held among the two most voted candidates and any other candidate winning more than 12.5% in the first round. The National Assembly election is almost, if not as important as the Presidency elections since the Assembly is the main legislative chamber of the French Parliament.

There are currently eleven candidates running for the French presidency, but with three clear front-runners – Emmanuel Macron (En Marche (On the Move) party), Marine Le Pen (National Front party) and Francois Fillon (The Republicans party). The agendas of these main candidates could not diverge more, from an EU exit and restoring a national currency (Le Pen) to more fiscal union with the EU (Macron), and from more welfare spending (Le Pen) to drastic labor market liberalization (Fillon).

Below we look at the prospect of each of the main three candidates winning and potential implications for financial markets.

Meet the Candidates:

Marine Le Pen (National Front party)
It is the rhetoric of Le Pen which has received the attention of investors globally. With the exception of Le Pen, all of the candidates are pro-EU and pro-Euro. Le Pen has campaigned on the following:

• Negotiating with Brussels on a new EU aimed at restoring France’s economic freedom from the Euro and closing France’s borders. If the outcome of the negotiations are deemed unsatisfactory, then a referendum for France to leave the EU would be held (Frexit).
• Leaving NATO
• Restoring France’s monetary sovereignty by returning to the use of the “new French franc.”
• Stop adhering to the 1973 law and subsequent European treaties which ensure central-bank independence by having a non-independent, government controlled, French central bank which would create money to fund government spending.
• Fighting the “two totalitarianisms” of globalization and Islamic fundamentalism.
• “Automatic” expulsion of illegal immigrants and legal immigration cut to 10,000 per year.
• Taxing imports and foreign job contracts.

Emmanuel Macron (En Marche party)
At 39 years old, Macron would be France’s youngest-ever president. He has never stood for an election before, but his political rise has been meteoric. Perhaps unsurprisingly, he has chosen a “centrist approach,” which in the French context means a social-democratic, pro-European path. Given his lack of a political background, there are still some details of his plan to be clarified, but he has campaigned on the following:

• Reducing public expenditures by 3% of GDP over the next 5 years.
• A €50bn (~$53bn) public investment plan to cover job-training, a shift to renewable energy and other infrastructure projects.
• Cut in corporate tax from 33% to 25%.
• Provide more leeway for companies to renegotiate 35-hour work weeks.
• Cut jobless rate to 7% from the current 10%.
• Pro-European, who would like to reinvigorate the EU, with the Franco-German alliance at the core.

Francois Fillon (The Republicans party)
When Fillon officially won the nomination of The Republicans for the presidency, he immediately became the polling favorite to win. However, in January his campaign was rocked by allegations that his wife and two children improperly received public funds. It is alleged that Fillon paid his wife and children around $1million over a number of years for parliamentary work, of which there is no evidence of them performing. At the end of March, his wife was placed under formal investigation for embezzlement, misappropriation of public funds, and aggravated fraud. Despite the controversy, Fillon has refused to step down claiming the charges are politically motivated. Fillon’s popularity has fallen dramatically and after being a clear favorite to win the presidential election is now polling third behind Macron and Le Pen.

From a policy perspective, his economic manifesto is ambitious, the main points of his plan are:

• Cutting half a million public sector jobs and the 35-hour work week.
• Removing the wealth tax
• Payroll tax would be decreased by 1.1% of GDP over time
• Corporate tax cut to 25%
• Decreasing unemployment allowances over time to incentivize early returns to employment.
• Change the retirement age to 65 years old.
• Favors immigration control
• Pro-European.

The policies for the three main candidates are summarized below.

The French elections are viewed as being important due to the impact for the bigger picture of the EU and the Euro. For investors, the concern is the potential for a Le Pen victory and the probability that she would be able to lead France out of the EU and Euro, if she was successful in becoming President. The prospect of France leaving the Euro would bring the future of the entire currency union into question and would likely result
in a period of destabilization in financial markets globally.

The Odds of Frexit:

There are six significant hurdles in front of Le Pen before she can lead France out of the EU and Euro, which are discussed in detail below.

Reach the Second Presidential Round
As discussed above, the first round of voting will take place on the 23rd of April. The polls currently indicate that no individual is expected to reach the 50% majority vote in the first round.

Win second presidential round to become President
While Le Pen looks likely to make it through the first round, she has to win an absolute majority of votes cast in the second round on May 7th to become President. However, her ability to win in the second round appears unlikely. In the second round, there are only two candidates and therefore the electoral dynamics are very different than the first round. The center and center-right vote, currently split between Macron and Fillon will likely converge to whichever candidate ends up facing Le Pen. The pro-European ideology of the other main candidates mean that it is more likely that their supporters and the other defeated politicians will rally behind her rival. The higher the turnout in the second round, the higher the bar will be for a Le Pen victory.

Furthermore, to date, there has not been a single poll released which has Le Pen winning the second round and with it the French presidency. Macron’s candidacy is looking stronger after a convincing performance in the first of the three TV debates, with the next two scheduled on April 4th and April 20th.

Macron (represented by the black line in the chart below) is currently the clear favorite with the betting markets placing odds of 64% that he will be the next French President, with Le Pen (orange line) in second place with 24.6% and Fillon (red line) the third most likely with around a 19.4% likelihood.

Following last year’s vote by the U.K. to leave the EU and the U.S. election results, many investors and political commentators have come to question the reliability of the polls. A common comment heard in the press was that the polls were wrong then and therefore cannot be used or trusted now. However, the polls and the betting markets remain an excellent source of information regarding the outcomes of elections. While both the U.K. ‘leave’ vote and Trump were behind in the average of the available polls going into their respective votes, the victories of either event should not have been a surprise. The average of the polls was wrong regarding who would win, but not beyond the margin of error in either case. In both cases, the average of the polls showed a very tight race and several individual polls correctly forecast the eventual winners.

Secure Parliamentary Support
If Le Pen is able to win the presidential race, she would need to secure parliamentary support to launch a referendum on the EU / Euro. In France, Parliament consists of two houses: The National Assembly and the Senate, which pass legislation and monitors the overall action of the government. The problem for Le Pen is that her National Front party currently holds only two of the 577 seats in the National Assembly and two of 348 senators in the Senate.

As discussed above, there are elections for the National Assembly on June 11 and June 18, in which the entire National Assembly will be renewed. Similar to the Presidential race, the non-proportional two-round system, will likely work against the National Front. Therefore, while it is likely that the National Front will be able to secure more seats, it is very unlikely that they will even get to 100 seats, let alone get to a majority.

Le Pen has acknowledged that she will “necessarily” have to go beyond the National Front ranks to build a majority. In this case, she would have to compromise with pro-EU parties and probably be forced to soften her Eurosceptic stance. If the opposition is combative rather than cooperative, she can always call for new elections. She could also choose to stay in minority, thereby handing parliamentary power over to the opposition. This would be the fourth time this has happened in recent French political history. Based on past examples of “cohabitation,” the opposition government then sets domestic policy while the President focuses on external affairs. That would make Le Pen a lame duck president from the start.

Negotiate with the European Union
If Le Pen manages to affirm her executive power at home, she can start bargaining on the European stage. She promised during her campaign to negotiate with Brussels before holding a referendum on EU membership six months later. According to her program, the objective of the talks is “to regain our freedom and control of our destiny by restoring the sovereignty of the French people (monetary, legislative, territorial, and economic).” Among other changes, this means installing border controls in France and exiting the Schengen area – the name given to the area comprising the 26 European countries which have abolished passport and other type of board control at their mutual boarders. Furthermore, it involves implementing a new French currency.

However, Britain attempted to have similar negotiations with the EU in terms of border controls before the U.K. referendum with very little success.

Win Frexit Referendum
In theory under Article 11 of the French constitution, the president can unilaterally call a referendum, however, such a vote cannot change the constitution. In addition, the constitutional court must approve the vote before it can take place. The court would likely block a referendum vote triggered under Article 11 which did not have congressional approval.

Even if Le Pen was able to organize a vote, polls suggest that the majority of French people do not want to leave the euro. As a founding member of the EU, pro-European sentiment remains high in France. According to a poll conducted just after the Brexit vote, 64% of respondents opposed an EU exit, compared with 48% in Britain. The Eurobarometer survey from October 2016 showed 53% of respondents viewed the euro as a “good thing” for France, with 37% regarding it as a “bad thing.

Trigger Article 50 and Change the Constitution
If Le Pen campaigns for Frexit and wins the referendum, she’ll get an implicit mandate to trigger Article 50 of the EU’s Lisbon Treaty and follow in the U.K.’s footsteps marked by several years of tough exit negotiations. France leaving the EU would require a change in the French Constitution which would have to be approved by the government and both chambers of Parliament.

Investing in Europe:

The market currently appears to be over-pricing the odds of a Le Pen victory and significantly overestimating the likelihood of France exiting the EU and Euro. Beyond the well-known political uncertainty in Europe, there are opportunities.

Growth and inflation data from Europe continues to improve. The most recent Purchasing Managers Index (PMI) hit a 6 year high and the latest economic surprises, as measured by the Citi economic surprise indices, in Europe have actually fared better than that in the US. Unemployment continues to decline, albeit from high levels, and both bank and corporate profitability is improving. Stronger bank balance sheets in conjunction with monetary easing from the ECB has increased bank lending to small and medium-sized enterprises which contribute 80% of the employment in the Eurozone. This increase in lending activity should help boost employment. The consumer inflation rate hit 2% year-over-year for the first time in four years.

There is a positive ‘right-tail’ scenario in Europe. In the recent Dutch elections, the pro-European incumbent Prime Minister Mark Rutte’s party, The People’s Party for Freedom and Democracy (VVD), won the most seats in parliament for the third time in a row, defeating populist leader Geert Wilders, whose party fared worse than expected. Wilders had run his campaign on anti-immigration and on holding an EU referendum (similar to Brexit). While Wilders party, the PVV, won 4 more seats than in 2012, the two main pro-EU parties, D66 and GreenLeft, gained 7 and 12 seats respectively – eclipsing the gain of the anti-EU party. In Germany, both leading candidates (Merkel and Schulz) are pro-European and could form an alliance between their parties after the elections which could result in an increase in public spending on infrastructure and defense. Furthermore, if, as the polls currently indicate, Macron was to win the French election, he has expressed a desire to form a strong Franco-German coalition which may result in greater fiscal spending as well as a focus on long-term European integration projects. In fact, there is potential for increased fiscal stimulus across the entire Eurozone. The establishment in governments are beginning to realize that unemployment and inequality is a fertile ground for populism and the best way to stop populist uprisings is to implement fiscal stimulus and other pro-growth policies.

Valuations in European stocks appear cheap relative to many other areas of the globe. Earnings estimates are being increased for European stocks. Compared to the U.S. stock market (Russell 3000), the forward price/earnings ratio for the European stock market (Stoxx 600), represented by the grey bars in the graph below, is 15.3x compared to 16.8x for the Russell 3000 (represented by the green bars).

This document is not to be construed as an offering or intended as a recommendation to buy or sell securities and is being provided for informational purposes only. These points represent the opinions of the author, and as such, should not be construed as investment advice.