30 mars 2017

European Political Risk Underestimated?

March 30, 2017, Jean-Jacques Ohana, CFA and Dr. Christian Witt (both YCAP Asset Management)

A series of recently published articles made us reconsider the chances of Marine Le Pen winning the upcoming French presidential election. In these articles, the author convincingly argues that (1) election outcomes are tremendously sensitive to voter turnout, and (2) deeply held prejudices can turn minority positions into political victory. The implications seem clear to us. Widely shared political prejudices––say skepticism of the EU or immigration––could discourage some voters to cast a ballot for mainstream pro-European candidates, although they principally oppose populist parties. Low turnout at the ballot box could then push the balance in favor of Marine Le Pen. So, should investors pay more attention than they already do?

On Voter Turnout

The starting point of our thoughts is the following argument developed by Serge Galam (a scientific version can be found here). If a candidate leads her contender in voter turnout, she does not necessarily need to convince a majority of the electorate to succeed. The minimum number thus crucially depends on the difference in voter turnout between the two candidates. Given the fragmentation of the starting field in the upcoming French election, Mr Galam concludes that the final contender of Ms Le Pen might struggle to mobilize sufficient voters on the Election Day. His corresponding simulations suggest that, with a mere opinion support of 42%, Marine Le Pen could still win a majority of votes if she succeeds in mobilizing 90% participation vs. 65% for her contender!

On Political Prejudices

Analyzing Trump’s triumph in last year’s polarizing campaign for US president, Mr Galam illustrates in a separate paper how hidden prejudices can turn a minority opinion into a political victory. His main point is that voters can be gradually convinced during successive debates to vote for a platform they initially oppose, if this platform is closer to their prejudices (or deep-rooted political beliefs). The counterintuitive implication is that polarizing political debates may yield tremendous advantage to a minority candidate.

Putting One and One Together

The application of both insights to the upcoming French presidential elections is straightforward. Perhaps the most prominent topic in the ongoing presidential campaign is France’s relation to the European Union. The positions of the three front-running candidates range from clearly pro-European (Macron) to modestly pro-European (Fillon) to openly anti-European (Le Pen). A look at the most recent two Eurobarometer opinion polls reveal growing (declining) reservations about (support for) the EU going back to the 1970s (see Figures 1 and 2). Today, EU sentiment is fairly split as 30.5% (33.0%) of voters oppose (support) the country’s EU membership. In fact, the current set-up does not look that different from Britain when the Brexit referendum took place. Given the high share of indifferent French voters (36.5%), it seems rather difficult for the two pro-EU forces to form a stable coalition. Their mission looks even more difficult once taking historical voter turnout (about 80.0%) into account (see Figure 3) which is close to the numbers considered in Mr Galam’s simulations. Already small variations could accordingly have substantial impact on the results. Therefore, we estimate that the current odds of success derived from bookmakers (see Figure 4) form a decent base rate; but any deviations are clearly skewed in favor of Ms Le Pen’s bid for presidency.

Note that the same reasoning may even better apply to Italy. Again, support for (opposition to) the European Union has dramatically vanished (strengthened) since the 1990s (2000s). However, voter turnout has risen even faster than in France (see Figure 5). Hence, the outcome of Italian elections expected sometime later this year or in 2018 should be even more uncertain than in France.

Since 2016, investors seem to have increasingly woken up to the nature of the elections’ risk as well. The gradual widening of the credit spreads between Italian and French government bonds and their German equivalent is evidence of this development (see Figure 6). Not only do both spreads move in lockstep, but keep converging to their pre-Euro levels.

Figure 1: Share of People with Negative Perception of EU Membership

Figure 2: Share of People with Positive Perception of EU Membership

Figure 3: Historical Voter Abstention in French Presidential Elections

Figure 4: Success Probabilities of the Three Frontrunners in French Presidential Elections as Estimated by Bookmakers

Figure 5: Historical Voter Turnout in Italian General Elections

Figure 6: Yield Spread between Italian/French and German 10Yr Sovereign Bond Yields