French elections: what to expect should Le Pen prevail

Should Marine Le Pen win the French presidential election, the immediate reaction of markets is likely to be a spike in volatility for French assets due to the uncertainty of what is to come.

Elections in April and May will see a new French president emerge. Recent polls suggest the National Front’s Marine Le Pen is a serious contender. Will the wave of political regime change that carried Britain’s Brexit vote and swept through to the US election continue in France? And if so, what impacts will a Le Pen presidency bring for investors and for business and financial markets in Europe and more broadly?
Marine Le Pen is the leader of the French national conservative party, the National Front (FN). Since 2011 she has led a movement to ‘de-toxify’ the party, relaxing some of its more extreme positions and expelling controversial members of the party, including her father in 2015. Le Pen’s election promises aim to treat and ultimately cure France’s ailments of high unemployment, high debt and a lacklustre economy with her pro-nationalist and protectionist proposals. Should she be elected president, her success would very much depend on the make-up of parliament and on having a cooperative prime minister. Regardless, a President Le Pen would signal change with the potential to alter the face of the EU.

Le Pen’s key proposals include:

• Six months to renegotiate membership of the EU or potentially trigger ‘Frexit’.
• The return of the franc.
• ‘Intelligent protectionism’ and trade tariffs.
• Lower taxes and better welfare.
• A harder line on immigration and stronger national preference.
• More security and defence spending.

Positioned as more of a right centrist candidate, Le Pen’s rhetoric, which champions a traditional France, may well win the allegiance of some of the wandering voters traditionally opposed to the FN.
These voters will expect Le Pen to stay true to her word and not revert to old-style FN policies. Others in the party may need to follow her example whilst trying not to lose existing voters, in order to have any hope of gaining enough seats in the parliamentary election in June.
Reminiscent of the 2015 UK election, Le Pen’s key promise is likely to be a referendum on membership of the European Union, along with a desire to reinstate the French franc. While her promises to renegotiate a better deal with the EU will sound all too familiar (particularly to those of us in Britain), she is undoubtedly in a stronger negotiating position than the UK was. France is a key member of the monetary union and Brussels will be all too aware of the danger of a second exit.
The ‘Franco-German axis’ has always been an integral part of the European Union, comprising just under one third of the population and almost half the GDP of the EU over the years. In recent years however some have suggested that France packs less of a punch with its relatively weak economy. The challenges that face the French economy include high and inefficient public spending, low economic performance, an incomplete rebalancing process and the obvious need for labour market reform. A national debt to GDP burden of 96% suggests France needs the EU, a point that Baron David de Rothschild emphasised when he denounced a potential Frexit as a “catastrophe”. However the relationship should not be regarded as one-sided. The EU, for its part, clearly needs France for many reasons – in particular, it is the largest producer of nuclear power in the Union (with a 51% share) and is integral to upholding the single currency.

The mood in France
Mistrust of the eurozone has become heightened.
The EU response to the global financial crisis focused on austerity measures rather than boosting economic activity and this has led to many feeling that France is being governed from afar. Many people feel that successive French governments have handed over the reins to the European Central Bank and this has led to increased support (even to extremes) for anything other than the status quo.

In previous elections FN support has been highly correlated to unemployment, once again indicating it was the marginalised population that voted to see change. Since the 2014 vote Marine Le Pen has garnered further support through a combination of the spread of populism; fear of terrorism and not least the frustration that people have had with President François Hollande’s broken promises. There is also a general feeling of mistrust towards international issues which has been growing as people around the world shy away from globalisation. France in particular seems to feel this more strongly than other European countries and concern around immigration has been heightened with recent terrorist attacks, perhaps making the FN seem like a more appealing option with its promises around protectionism.
Youth unemployment remains a key issue, with latest reports putting the figure at 26.2% as at the end of 2016 – near to the all-time high for France. This is one of the key issues Le Pen must tackle.
Although the FN manifesto does not focus exclusively on this issue, the hope is that by effectively fining companies through additional tax for hiring non-French employees, this will naturally lead to greater numbers of French youth being hired.

However, this is only part of the issue. As the former prime minister, Manuel Valls, acknowledged, France’s labour laws make it easier to employ temporary staff. The lack of available permanent positions for the young leads to a whole host of issues, including an inability to rent or buy homes, as well as a reduction in consumption causing the French economy to suffer. With an ageing population, the importance of getting the young into the workforce is ever more pressing.

What hurdles would Le Pen face?
The parliamentary elections are held a month after the presidential vote, and the results will determine how much (or how little) power Le Pen would have. An elected president does not have full control unless a majority parliament (289 seats) is secured – which is close to impossible for any of the candidates. Given that an FN-majority parliament is unlikely, a coalition government would have to be formed and the prime minister would be elected from the majority party in parliament. Under a coalition, President Le Pen would have a number of limitations on her power, as detailed in Figure 3 below.

Le Pen harbours plans to renegotiate terms with the EU (including a return of complete power over immigration controls and economic policy to France) and to hold a referendum if she doesn’t get a better deal for France. In order to call a referendum Article 89 must be used, which requires approval of 3/5ths of parliament or the prime minister. As such, either the make-up of parliament or who Le Pen appoints as prime minister becomes vital. There may be a chance that a strong-willed prime minister could put a spanner in the works and block a referendum on EU membership. But it’s hard to envisage a government standing in the way of those who voted for Le Pen in full knowledge that a referendum would be imminent with her victory.
And what if Le Pen gets her referendum? While recent polls have indicated an increased likelihood for French voters to choose Frexit, there is an understandable reluctance to leave the single currency due to fears of a devalued currency and the impact on individuals’ savings and mortgages. Le Pen has responded to this concern by stating that “A European ‘currency snake’ is reasonable. A national currency coexisting with a common European currency [the ECU] will have no impact on daily life.” This is perhaps somewhat optimistic. France leaving the euro will have a significant knock-on effect on the wider economic currency union. We saw sterling plummet following the UK Brexit vote, which helped to manage the significant current account deficit by increasing the appeal of UK investments. However in France it is primarily the structural issues in the labour market that need to be addressed, and these issues won’t be helped by devaluation of the currency.

What can we expect from markets?
Financial markets have already priced in some uncertainty in France, as shown in Figure 4 below.
French government bonds have been somewhat skittish since Trump won the election in the US as they pre-empted the risk of a Le Pen victory.

The immediate reaction of markets is likely to be a spike in volatility for French assets due to the uncertainty of what is to come. As a Le Pen presidency is perceived to increase the likelihood of France’s withdrawal from the euro, in the event she wins the election we would expect the spread of French bond yields over German bunds to widen significantly. As a benchmark, that spread reached around 150bps at the height of the eurozone crisis in 2011/12 and it’s quite possible that it would approach that level once again. Similarly, other peripheral and semi-core bond spreads would widen, consistent with an increase in break-up risk.
On the equity side, the European market could see a drop of as much as 10% immediately triggered by uncertainty about what this could mean for the EU, along with a potential wider hit to global markets. Companies with good fundamentals in sectors less impacted by geopolitical events should be fairly resilient. Returning however to the euro-denominated debt issue, the largest hit will likely be European banks which could move down by 20-30%, having lowered 20% in response to Brexit. Brexit is an arguably insignificant event in comparison to the break-up of the EU as with countries returning to their pre-euro currencies there will be a significant mismatch in assets and liabilities for banks still denominated in euros.
European banks have been at the precipice of a crisis for many years now, not least when Greece was reaching the stage of falling out of the European Union. In the medium term, with the state that the Italian banking system is currently in, its banking sector is unlikely to be able to withstand the fallout of a euro collapse. And it is not just those countries that are heavily indebted that will be affected, but also the likes of Germany (with its holdings of French and Italian debt).
According to the European Law Journal “..private sector financial lenders would immediately increase their pressure (‘spreads’) on Member States that have not yet left the euro, thus causing the incalculable costs of a domino effect that eventually would also threaten the economy of the trade surplus countries because they would lose substantial parts of their export markets.”
Certainly the interconnected EU banking system will be at the biggest risk of collapse, with consequences for the financial sector globally.
However the hurdles to Frexit would remain high and a more considered reaction may follow, even under a Le Pen administration. In this scenario some premium and curve steepness should probably remain, reflective of a more inflationary, less fiscally conservative policy mix. Likewise, French inflation-linked bonds, currently implying breakeven inflation rates of around 1.31% over 10 years, would perform strongly.
Looking further out to the medium term, if there was to be a break-up of the euro, this would cause the newly established franc to come under pressure as investors attempted to hedge risk by selling the currency. The traditional interventions to counteract a plummeting franc would include increasing interest rates in France and selling euro asset reserves to buy French bonds to help strengthen the currency. Such measures come with their challenges for a government trying to prevent damage to the economy and without a substantial euro-denominated reserve pool. As for other newly-resurging European currencies of old, the Deutsche mark would strengthen while the Italian lira would fall. There may in fact be a silver lining for Italy and Greece, in the form of the much longed-for depreciation in their currencies.
The renationalisation of monetary policy would allow countries to devalue their currency, but would also magnify the issue of repaying the eurodenominated debt.
The first round of the presidential election will be held on 23 April following which – should no candidate win a majority – a run-off election between the top two candidates will be held on 7 May 2017. In a world that feels increasingly unpredictable, all eyes will be on France.

Mark Burgess – CIO EMEA and Global Head of Equit – Columbia Threadneedle Investments