The Algebris Bullet

The Silver Bullet | Don’t Fret about Frexit

After Brexit and Trump, investors have entered 2017 cautiously and are not willing to take any chances on Europe’s upcoming elections.

There are indeed reasons to worry. Anti-Euro candidates Marine Le Pen in France and Geert Wilders in the Netherlands have been topping the polls until recently. Meanwhile, the UK is preparing to start its divorce negotiations with the EU. Greece faces a big debt redemption in July, while its debt negotiations have stalled.

Complexity and political uncertainty are high, but fundamentals are strong and European institutions have untapped ammunition. Hedging eurozone break-up, buying bunds at negative yields and shorting the Euro are popular trades now. But beyond the populist rhetoric, there is often little substance: Europe has been limping along for years without breaking up. Soon investors could find themselves into a positive scenario they’re unprepared for.

Our Base-case: A Macron Victory

The French presidential election operates on a two-round system: should no candidate win a majority in the first round on the 23rd of April – the most likely scenario – then the top two candidates will enter a run-off election to be held on the 7th of May.

The top three contenders are populist Le Pen, reformist Macron and republican Fillon. Recent polls have shown a strong lead for Emmanuel Macron, previously the underdog. The game-changer for Macron was both the endorsement by Francois Bayrou, a notable centre-right potential candidate, as well as the scandal engulfing Fillon’s candidacy. So far, Mr Fillon has pledged to stay in the race, despite allegations of corruption. We estimate the following final outcomes:

72% probability: Macron wins

19% probability: Fillon wins

8% probability: Le Pen wins

While Ms Le Pen is the most likely candidate to enter the second round based on current polls, she actually stands a very low overall chance of winning. This is because the centre and centre-right vote, currently split between Mr Fillon and Mr Macron, is then likely to converge. We estimate only a 15% probability of her beating Fillon and 6% probability of beating Macron in the second round. Our analysis uses a Monte Carlo approach, correcting for poll bias and simulating tail risk, as explained below.

There’s also a fourth scenario: should  centre-left candidates Mélenchon and Hamon decide to form a leftist alliance, there could be greater uncertainty over who will be facing Le Pen in the second round. However, so far both Mélenchon and Hamon have ruled out this possibility given their fundamentally different views on EU issues.

What Happens if Le Pen Wins?

Even if Ms Le Pen wins, redenomination risk is low. In the FN’s Les 144 engagements présidentiels, Le Pen details her ambitions to target 2% GDP growth by 2018 partly through tax cuts to SMEs and individuals in lower-income brackets. More importantly, she also plans to renegotiate EU membership and to break the single-market with a tax on imports.

We see a very low probability (14%) of Le Pen progressing on her Euro-exit agenda, even in the unlikely event of her winning both rounds of elections. For Le Pen to deliver on Frexit, she will need approval from France’s bi-cameral parliament. France’s parliament is split between the Assemblée Nationale and the Sénat. In theory, both houses need to pass legislation for it to become law, but in practice the final decision rests with the Assemblée Nationale. However, Le Pen’s FN party currently only has 2 of the 577 deputies in the Assemblée Nationale. The next elections for the Assemblée Nationale will take place on the 11th and 18th this June, but the latest poll suggests that FN is only likely to get 58-64 seats, still far short of a majority.  Additionally, FN has no deputies in the Sénat. Only a third of Sénat deputies are up for re-election every three years. This means the earliest the FN could control the Sénat is after three years, in 2020.

Markets currently overestimate the risk of currency redenomination. If we assume that French debt in local currency would be worth around 20 cents below its German equivalent, then market prices imply a 5% probability of redenomination: the 1% yield differential in 2-year French vs German bonds is roughly equal to 5% probability times a 20% loss given Frexit. Instead, we estimate a 1% probability of redenomination on French sovereign debt (8% probability of Le Pen winning elections, times a 14% probability of a referendum winning).

Macron: Reforming France and strengthening the EU. A potential victory for Macron would likely be the best scenario for France and for Europe, in our view, given his strong pro-reform and pro-EU agenda. His key proposals, while ambitious to pass, include the creation of a Eurozone budget administered by a common Minister of Economy and Finance, commitment to meeting EU deficit targets, a €50bn investment plan and reforms to the job markets (see table below).

In addition, a Macron victory combined with a potential Merkel-Schulz coalition in Germany could lead to a strong Franco-German coalition, paving the way for European integration and much-needed fiscal stimulus.

Fillon: the alternative positive scenario. Mr Fillon’s campaign has run on the promise of challenging the French “software”. His agenda includes revising the 35 hour work week, rewriting the entire 3000 page labour code, firing 500,000 government employees and getting rid of the wealth tax. While less radical than Macron’s promise to further European integration, Fillon’s programme should still be positively received by markets.

Conclusions: There’s Growth at the End of the Political Minefield
  1. Our base-case scenario for France is that Macron wins in the second round on May 7th. This could lead to a very positive scenario for Europe, with Macron partnering with Merkel or Schulz in Germany to form a strong Franco-German coalition. This may result in greater fiscal spending as well as a focus on long-term European integration projects.
  2. We think markets are over-pricing the chance of a Le Pen victory and currency redenomination risks. In our view, even if Le Pen is elected, her party will not control the Assemblée National nor the Sénat. In addition, even if there is a referendum on EU membership or on the Euro, we estimate a low probability of passing a Frexit vote (14%).
  3. 2017 has been seen as a political minefield for European investors, but the potential bombs are being defused one by one: Le Pen is unlikely to win in France. In the Netherlands, Geert Wilders has seen a decline in recent polls and will likely have limited control on parliament even if he wins. In Germany, both leading candidates are pro-Europe and could form an alliance post elections, increasing public spending on infrastructure and defence. In Italy, Mr Renzi is running to lead the Democratic party and planning a come-back. Populism has its economic roots in rising inequality and disenfranchisement. While the US and UK have outgrown Europe over the past decades, they also rank highest for inequality. As we wrote in the Financial Times last month, Europe’s social safety net and welfare policies could now turn from weaknesses into strengths.
  4. There’s growth and reflation at the end of the political minefield. Strong macro data and a recovery in corporate fundamentals make Europe a good investment after the political dust settles. Growth data is solid, inflation is normalising, investment is coming back to periphery countries which implemented reforms and banks are starting to lend again (The Silver Bullet | Don’t Give up on Europe). We see value in European risk assets in the infrastructure, energy, defence and financial sectors.

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