French election opens door to big market reaction

For the third time in less than a year investors face another rendezvous with capricious voters, who may well be leading pollsters astray.

After the UK vote for Brexit and the election of Donald Trump, the first round of France’s presidential election beckons with markets at an inflection point.

Reflecting the risk of a shock result in which Marine Le Pen, the leader of the National Front and/or Jean-Luc Mélenchon, the far-left veteran, exceed their current polling, a number of market barometers are flashing.

In our era of populist candidates, both Le Pen and Mélenchon have called for serious changes in France’s relationship with the EU. A chief anxiety for investors is Ms Le Pen’s ambition to pull France from the euro and return it to the franc.

With only days before Sunday’s first round, implied measures of volatility for the euro are above the closing peaks touched during the Brexit vote, and at levels last seen regularly back in 2011 during the eurozone’s debt crisis. Another key measure of angst shows France’s bond yields at their widest to German debt since late 2012.

Yet for all those impressive — and alarming looking — spikes, fear isn’t the only market emotion in the countdown to the first round. Other price action in the market reflects a belief that the French voter will ultimately steer clear of extremes, and instead install a centrist candidate such as Emmanuel Macron, a former economy minister under the current Socialist government in the final round of voting on May 7. Such thinking has been nurtured after the Netherlands voted for the status quo in March.

European equity market implied volatility based on the Euro Stoxx 50 index, for example, still remains some way below the peaks seen in June when the UK voted to leave the EU.

This tells us that traders and investors think the first round of voting provides the prime opportunity to get a lot more bullish on France. This means volatility measures are ripe for selling, while France’s beaten-down sovereign bonds are a buy alongside the euro.

Richard McGuire, head of interest rate strategy at Rabobank, thinks there is “a chunk of investors who will look to get long before the first round election result rather than waiting for confirmation that polls have been painting an accurate picture”.

The premium for 10-year French bonds over Bunds has generally been around 40 basis points in recent years, so the current spread above 70 bps is certainly enticing for traders willing to bank on a middle-ground candidate eventually winning.

We have already seen money flow into Europe, ignoring the sight of various volatility measures straining at the leash like a half-starved whippet.

Global investors have been rotating out of expensively valued US shares and buying those in the eurozone. France’s CAC 40 index benchmark, though, has lagged the performance of equity benchmarks in Germany and Spain. Meanwhile, the CAC Mid 60 index of medium-sized companies stands roughly 7 per cent higher for 2017, reflecting confidence among domestic investors that election worries are overstated.

Indeed, some in the market suspect further erosion in the polls for Ms Le Pen could yet open the door for a second-round run-off between Macron and François Fillon, the former frontrunner whose campaign has been mired in scandal.

The most favourable market outcome from Sunday would involve such a centrist showdown in the second round. It would raise hopes for a faster pace of economic reforms and significantly bolster asset prices.

Throw in signs of faster global growth, and the anticipation of some rare fiscal easing from Germany as election campaigning picks up steam in the eurozone’s biggest economy, and it’s easy to make a case for the money flows into the eurozone accelerating.

But for all the quiet confidence among investors that the market risks are “tilted to the upside’’ on this election, all we have from voters are their intentions, not their votes. The likelihood of a sizeable market reaction looms large next Monday, particularly if the polls prove wide of the mark and the French voter favours populism.

michael.mackenzie@ft.com