After the Brexit vote in the UK and the Trump electoral victory, many investors are worried about Frexit. What will happen to asset classes if Marine Le Pen wins on April 23rd? We break this down into three questions. Firstly, is it priced in? Secondly, how bad could it get. And thirdly, how likely is Le Pen to win?
Starting with the pricing question here are two European equity markets. Instead of looking at index prices we've looked at the volatility. Think of this as a "fear gauge". When volatility is high markets are in a state of panic. When volatility is low markets consider everything to be fine. GFC means the Global Financial Crisis in 2008 and you can see that for the DAX and European stocks volatility blew past 50% during the crisis. SDC is the Sovereign Debt Crisis in Europe when investors started to worry that the euro single currency would break up. Here volatility rose above 40% but it wasn't as bad as the Global Financial Crisis. So what does this barometer of fear tell us about markets now?
The stock market seems to think that everything's fine in Germany, more widely in Europe, but also in the US. And so it's fair to say that a Marine Le Pen victory is simply not priced into equity markets.If we look at the European stock index, which is the FTSE Europe excluding the UK, from peak-to-trough in the Sovereign Debt Crisis in 2011/2012 the index fell by about one third. As one of Marine Le Pen's central policies is to break up the euro and return to the franc one might expect a selloff in the equity market to be more severe than this, perhaps closer to the magnitude of the Global Financial Crisis than the European Sovereign Debt Crisis.
European government bonds are telling a very similar story. How likely is it that a government will default on its debt? Well, one way to measure this is to take the ten year interest rate, subtract the German interest rate, and we assume the extra interest you receive is for taking the credit risk of that country. So the bigger the spread in rates to Germany the bigger the credit risk for that country. You can see the spike in those spreads in 2011.
That split European countries into two groups: the core and the periphery. Some people call France a pseudo-core country because its spreads weren't as tight as Germany but they weren't as bad as countries such as Italy, Ireland and Portugal. And you can see that currently those spreads are very tight. We're well past the Sovereign Debt Crisis.
But as worries start to grow that Le Pen could win the Presidential Election the French spread is starting to increase. In this FT story, you can see how the spread increased from 0.3% to 0.8% over the last four months. And a large part of that is due to the risk that Le Pen will win the election. So while the equity markets are still quite sanguine, the bond markets are starting to price in that risk.
Why is it a risk? All of the massive bond markets in Europe would have to be redenominated from euros back into the domestic currencies of the member states. One of Marine Le Pen's advisors, Bernard Monot, thinks that redenominating France's two trillion euros of national debt into the "new" French franc will not be a catastrophe. Because he thinks that investors will understand that they're "working as patriots to restore France's sovereignty". And we don't have to worry he has a plan. It's in his head!
Here are two ways to monitor the outcome of the French Presidential election and both of them update daily. The first is to take a look at Ladbrokes. Their favourite to win in round one is Le Pen and the assign the greatest likelihood that Macron and Le Pen will go through to a second round in which Macron will win. Alternatively you can look at IFOP.com which is in French, and they do a daily poll which is, of course, highly reliable, on the outcome of the election.