The Risks of the French Election and How to Play Them
Elections and votes have been among the worst nightmares of politicians and some investors as well. The Brexit vote last summer, the Italian constitutional referendum, the Dutch elections, and of course Donald Trump’s march to victory all stirred up markets, especially because of the huge errors made by polling companies and other forecasters in some cases. The outcomes of these votes were sometimes irrelevant for the big picture, but in the case of Brexit and the US elections, the final result defined trading in financial markets for a longer period of time.
The Great British Pound fell to a 35-year low below the 1.20 level against the Dollar after the Brexit, even though the pair was as high as 2.10 before the credit crisis, and still breached 1.70 in 2014. Those familiar with currency markets know that this move is YUGE! Then there was the “Trump-rally” that ignited US stocks to new all-time highs towards the end of last year, especially boosting the financial sector and industry-related companies.
The Next Big Thing
We are quickly approaching the next possible political earthquake, the French presidential election. As the country’s political system is strongly centered around the President, this single vote can define the direction of the second biggest power of the EU for the coming years or even decades. The country faces several political and economic problems, which could grow into a full-blown crisis if the steam runs out of the global recovery or a populist candidate gets elected. Because of this, the elections can provide great trading opportunities in the coming weeks.
The French Election System
The election consists of two rounds (if no candidate gets 50% in the first round), with the winner and the runner-up of the first round “qualifying” to the second, decisive run-off vote. The first round will be held on the 23rd of April, while the likely second round is scheduled for the 7th of May.
As of now, there are four candidates with a realistic chance of making the second round and winning the election. The traditional right is divided by far right candidate Marie Le Pen and more centrist Francois Fillon while the left is dominated by pro-EU and economic reformist Macron, and the rapidly rising “Trumpesque” anti-EU candidate Melenchon.
|Chance of Winning||Frexit possible?||Trade||Taxes||Immigrant Policy|
For financial markets, Macron and Fillon are the “positive” candidates, representing the establishment, with some possibly progressive economic reforms that could mitigate the economic and social problems. Le Pen and Melenchon are definitely the anti-establishment candidates, and even the hint of their election could result in “flight-to-safety” and a significant sell-off in risk assets. The Euro got under pressure lately as Melenchon gained in the polls in the past two weeks.
Under Le Pen and Fillon even a Frexit vote might be in the realm of possibilities, although given the popularity of the EU, and the French constitutional system, it is a highly unlikely outcome. The other most important differences in the candidates’ programs are also listed in the chart above.
As there is a huge difference between the candidate’s first round and second round chances, for now the closest we can get to predict the market’s reaction is to look at the polling numbers for the candidates and the chances of the different pairings for the second round.
|Candidate||1st Round Polling Average|
Currently, it’s very important to look at the chances of the different face-offs in the second round of the referendum as well:
|Pairing||Chance of Outcome|
Right now Melenchon’s rise is the most important tendency, as it makes some “horror” scenarios more likely. Melenchon is drawing in inactive voters while also attracting the voters of Hamon, making the last weeks that much unpredictable.
As for trading, the divide in the centrist field between the moderate candidates makes a tail-risk event more likely in the first round. The highest probability Le Pen-Macron and Le Pen-Fillon face-offs will probably lead to the success of the moderate candidate, but a further surge in the popularity of Melenchon could raise the chances of a Le Pen-Melenchon face off.
That said, even if one of the two most likely pairs make the run-off round, Le Pen might cause a surprise, despite her base being less flexible. We see more uncertainty regarding the first round, with plenty of room for the market to “get scared”.
Let’s take a look at the ways of betting on a shocking result:
Buying generic safe-haven and risk-off assets:
- Japanese Yen, Swiss Franc
- US Treasuries, German Bunds
- Volatility ETFs (VIXY, or to a lesser extent VIXM)
Selling or shorting generic risk-on assets:
- Copper and other industrial metals
Event specific assets:
- Shorting the Euro
- Selling (shorting) French and Eurozone equities, French bonds
- Playing the widening of the French-German government bond yield-spread
- Playing contagion: shorting Italian equities and government bonds
Should the surprising result materialize, it is important to note that not all affected assets will produce sustainable moves. Thanks to the low-interest rate policies around the worlds, stocks are still in a global bull market and they will likely recover, at least temporarily, even if a negative outcome materializes. Stock market tops are processes not one time events, but a scary French result will be a huge blow that could trigger a major correction in equities, especially in Europe.
The long-term downtrend in the Euro/US Dollar pair, Weekly Chart analysis
On the other hand, the Euro might start another leg down in its multi-year decline, targeting at least parity with the US Dollar. Government bonds are likely to diverge in the Eurozone, as break-up fears get stronger, and trust in the monetary union deteriorate. Conversely, if Macron or Fillon wins the election, expect a healthy bounce in the Euro and European equities, although, given the recent escalation in international politics, a lot of unpredicted things might happen in the next three weeks.