April 13, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)
Over the last couple of weeks, markets have been clueless. Some ups, some downs. But nothing dramatic; not even a correction that is worth the name. In our view, this is due to formidable tail risks––most notably an accidental, disorderly breakup of the Euro Area in the wake of upcoming French elections. More than ever, investors may need to keep their nerves.
France Decides the Fade of the Euro
The odds could hardly be higher for investors when two pro-European establishment candidates (Fillon and Macron) will face nine euro-sceptic or non-establishment contenders (e.g. Le Pen, Melenchon) in the first round of French elections on April 23, 2017. To give you an impression, imagine the best and worst outcomes. If both Fillon and Macron proceeded to the second round, markets could rally sharply in response to what may be construed as some sort of political stability. By contrast, should both fail in the first round, there would be a real risk of financial meltdown. For the victory of two euro-sceptic candidates would immediately fuel speculation about France’s future in the common currency. As a result, investors might move their investments out of the country without delay; perhaps even in panic. Likewise, French banks could see massive cash outflows as wary French citizens steer their money out of the country before a newly elected president could establish capital controls by decree. The script would be like the one of Greece in the summer of 2015 after the euro referendum or the Cypriot banking crisis at the end of March 2013. Only that France is much more important for the euro zone––in political, economic and financial terms.
One immediate consequence of France’s euro departure could be the collapse of the common currency in a single big blow. For other economically vulnerable countries which turn increasingly anti-European, such as Italy, Greece or Portugal, could follow suit. As we have argued on several occasions (Italy in Peril, Europe: Running Out of Time, European Reflation: Boon or Bane), the economic troubles these countries have will not disappear anyway, even if France votes pro-European. But a French populist victory could cause the barrel to overflow bringing the euro down in the process.
One should not make the mistake of underestimating the probability of such a worst case to materialize. For instance, the 10 most recent poll suggests a neck-and-neck race between the four leading contenders within the error margin (see Figure 1). And this ignores that a majority of voters may already support anti-establishment platforms when the field is divided into a pro- and anti-European camp (see Figure 2). Although indications from professional bookmakers show an advantage for pro-European forces (see Figures 3 and 4), the current momentum clearly favors the anti-establishment movement. Media coverage further has the potential to reinforce the trend since all candidates are given equal time on popular French radio and TV shows. Given that 9 out of 11 candidates advocate an anti-establishment platform, this translates into an effective media coverage of more than 80%. On top of all that, 30% of French voters are still undecided and voter turnout could tip the balance in favor of anti-establishment, euro-sceptic candidates anyway. Hence, a success of pro-European forces is far from certain, so that formerly unimaginable scenarios become a real possibility.
Crisis management is the third factor investors should bear in mind in the case of euro-sceptics winning the presidential bid. For the election procedure may create an unholy power vacuum between the presidential and the parliamentary elections. Beyond that, the absence of an independent national central bank could block the provision of unlimited emergency liquidity to banks unlike after the Brexit referendum last year. Meanwhile, the ECB may hesitate to provide liquidity to a member central bank whose future government plans to exit the Euro Area. Thus, the existing institutional framework seems ill-equipped to handle a success of euro-sceptics in the elections…
A Double-Edged Sword… or Straddle
On the night of April 23, 2017, reality will begin to supplant uncertainty––for better or worse. A mainstream victory may clear the way of political risks until the next Italian election. Risky assets should rally as a result since political risks no longer overshadow the strengthening economic recovery in the Euro Area. By contrast, a populist victory could spark financial chaos.
In the terminology of the options market, this setup resembles a straddle (combination of long call and long put). A straddle buyer speculates on strong market moves, both up or down. If markets do not move a lot, however, the options will expire worthless. What makes this illustration so appealing to us is that the current pre-election ‘equilibrium’ seems inherently unstable. Before an election, the average of potential ‘heaven’ and ‘hell’ outcomes may give ‘normal’, but after the fact it will either be one of two extremes.
Against this background, risky assets have been directionless for several weeks now. Stocks, copper or the USD, have essentially gone nowhere over the last month (see Figure 5). Simultaneously, traditional safe haven assets (Gold, US T-Notes, UK Gilt, German Bund) have moderately gained (see Figures 6 and 7). However, haven assets with a potential exposure to currency risk, say French or Italian bonds, sold at a substantial discount to their German equivalents as the widening yield spread illustrates (see Figure 8). Hence, in anticipation of the big event, markets appear to start de-risking their portfolios at least in fixed income and currency markets.
Some Allocation Ideas
To exploit this setup, investors should seek to skew their portfolios towards a straddle-like payment schedule. They may to some extent exploit the situation even without directly purchasing straddles. This is particularly true for investors with a Euro Area bias.
For starters, investors could substitute some equity exposure with bonds, cash or precious metals. However, some more effort is needed to manoeuver the « euro break-up » risk. Under a populist scenario, the euro will temporarily slump until France effectively leaves the common currency (at which point the euro will likely rally again as Germany’s relative weight increases). By contrast, French assets should disproportionately slump due to the risk of poor crisis management. Therefore, investors should overweight non-euro safe haven assets or at least those that will remain EUR denominated. Gold, bonds or currencies of sovereign developed countries (e.g. US T-Notes, UK Gilt, JPY, USD) satisfy all these criteria. But German or Dutch sovereign bonds could also be a worthwhile alternative. Under a mainstream scenario, the euro and risky assets should rally as the burden of political risks suddenly vanishes. Hence, investors should privilege Euro Area equities on the risky part of their allocation (within the risky bucket French and Italian stocks should be underrepresented). This way investors could optimize their asset allocation even in a traditional long-only portfolio.
To sum up, although our discussion has been focused on the downside of French elections, this big political event could mark an inflection point for better or worse. Moreover, investors can exploit the current extraordinary and thus temporary market conditions to adjust their asset allocations. One way would be to diversify their risk-off assets (bonds, currencies, precious metals) outside the Euro Area while concentrating risk-on assets (equities) in the Euro Area (but not in France or Italy).
Figure 1: Median Estimate of 10 Latest Polls for First Round of French Presidential Elections (3% Margin of Error):
Figure 2: Aggregate Median Estimate of 10 Latest Polls for First Round of French Presidential Elections by Political Orientation (3% Margin of Error):
Figure 3: Probability of Winning both Rounds of French Presidential Elections (Estimated by Professional Bookmakers):
Figure 4: Probability of Winning both Rounds of French Presidential Elections by Political Orientation (Estimated by Professional Bookmakers):
Figure 5: S&P500, Copper and USD Performance since the US Election
Figure 6: Gold Price in EUR and USD
Figure 7: 10-Year Government Bond Futures (USA, GER, JPN):
Figure 8: Spread between 10-Yr German Sovereign Yield and the Equivalent Yield on French/Italian Government Bonds
Published on Riskelia’s Blog