Prophets

Bond Investors Shouldn't Panic Over French Elections

Europe’s political turmoil may spell opportunity.

To the second round?

Photographer: Marlene Awaad/Bloomberg

Investors in European bonds showed increased concern last week about the outcome of France’s presidential elections. The spread between French and German 10-year obligations widened as the far-left candidate Jean-Luc Mélenchon rose in the polls before the first round of elections on April 23.

Many investors had expected a mainstream, pro-euro candidate to win the second and final round on May 7.

Yet four major party candidates -- Mélenchon, Marine Le Pen from the far right, and two mainstream politicians, François Fillon and Emmanuel Macron -- are now bunched together in most recent polls. That raises the odds of a showdown between two extreme competitors in the second round. Adding to the uncertainty and investor concerns, about a third of voters have not made up their minds.

Both Mélenchon and Le Pen have promised to take France out of the euro zone. The leftist’s threats to impose a 100 percent tax rate on those with monthly incomes above 33,000 euros ($35,154), to lower the retirement age to 60, and to reduce the workweek from 35 hours to 32, have also unnerved investors.

The spread in yield of French 10-year bonds over German bunds (Europe’s equivalent of “risk-free” debt) rose from 67 basis points at the beginning of the month to 73 basis points late last week (solid line, right scale on the chart). The spread had been below 50 basis points at the beginning of 2017, when investors felt confident that a mainstream candidate would be the eventual victor. With an anti-Europe candidate leading in the Italian elections expected to be held in February 2018, the Italy/Germany spread widened along with French debt (dotted line, left scale).

What is behind the market concern expressed through wider French and Italian yield spreads? Holders of these obligations fear that if the euro were no longer the medium of exchange in France or Italy, the debt would be restructured and repaid in new French francs or new Italian lire -- or whatever national currency replaces the euro. And since these currencies would likely depreciate against the euro and the dollar, bond-holders would suffer capital losses.

Although there is no telling which way the first round of French elections will go Sunday, a victory by Mélenchon or Le Pen could, counterintuitively, provide a buy signal for investors in various asset classes. This despite what would likely be the immediate reaction of markets to such a result -- a steep fall in French and Italian equity prices, and a further widening of debt spreads with respect to Germany.

Still, there are reasons to believe that the loss of mainstream candidates may yet enable attractive medium-term investment returns. While I focus on France below, many of the implications extend to Italy as well.

First, neither Le Pen nor Mélenchon will be able to unilaterally take France out of the euro zone. Despite the rise of these two candidates, various polls suggest a 70 percent to 80 percent French popular support for continuing to have the euro as the national currency. A determined push by the new president to form a new currency is likely to be defeated in a national referendum.

Second, a proposal to form a new currency will also have to be approved by the French National Assembly. And since a Mélenchon or Le Pen victory will not be accompanied by a parliamentary majority for the new president’s party, France may end up with a prime minister of a different party -- a power-sharing arrangement known in France as cohabitation. Historically, these situations have made it extremely difficult for a president to make major structural changes.

Third, let’s assume that, despite these stumbling blocks, the new French president manages to take the country out of the euro zone and restructure its debt. He or she would still have to undertake measures to lower the youth unemployment rate, the Achilles’ heel of the French and Italian economies (chart below, France on right, Italy on left). 

The new leader will have to offer incentives for equity investors, and ease regulations and lower the tax burden, to enable more job creation for workers between 15 and 24 years of age. It is not surprising that the youth vote, disenchanted with years of political sclerosis in France, is going in a big way for Le Pen.

Regarding debt, investment at high yields in French debt redenominated in new francs may prove to be a shrewd move. Steps taken to make it easier to fire unproductive workers, for example, would create jobs for the young and, thereby, reduce the yield on debt as well.

Although investors would breathe a sigh of relief if a mainstream candidate were to win, the medium-term return in markets may be even greater if an extremist candidate becomes the new president.

In sum, by forcing an end to decades-long measures that were hurtful of financial markets, Europe’s political risk may spell opportunity for investors -- no matter the outcome.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

    To contact the author of this story:
    Komal Sri-Kumar at ksrikumar1@bloomberg.net

    To contact the editor responsible for this story:
    Max Berley at mberley@bloomberg.net

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