Lots of political risks
Among all the risks to the current blue-sky market conditions that we highlighted in this letter last month, political risk is to some extent the most prevalent and uncertain of all. Prevalent because there are at least 5 political events of significant importance taking place in the EU this year, affecting 4 of the 6 founding members of the EU. First, the Dutch general election in March where the far-right Eurosceptic PVV is leading the polls; although it is unlikely to lead a coalition government, it could try to force a referendum on EU/Euro membership afterwards. Second, the UK government is expected to trigger Article 50 of the EU Treaty before the end of March to request an exit from the EU within two years. This would mark the beginning of the real negotiations framing the terms of (i) the UK’s exit from the EU and (ii) the UK’s post-Brexit relationships with the EU – its largest trade partner by far. Then come the French presidential and general elections in May and June – more on that later. In September, the German federal elections take place and could see the first MPs from far-right party AfD being elected as well as changes in the ruling Merkel-led coalition. Last is Italy where the general elections could take place as early as this spring and no later than Q1 2018, depending on the results of the Parliament debate on electoral reform. Importantly, political risks are also uncertain because the outcome of such events is hardly predictable at this stage and predictions for similar events have recently proven useless if not misleading. Such uncertainty is also enhanced by the fact that the price action in credit markets following unpredicted and potentially negative election outcomes has been muted if not contrarian in the recent past.
France at the center of European political risks
Political observers have long argued that the French electoral system for the presidential and general elections – based on a two-round vote with no proportional representation – was limiting the odds of some non-mainstream leadership being elected. The trouble is that such assumption may not be proven right this time, which makes the “Le Penenchon” risk real for Europe’s second largest economy. Let’s be more explicit about what we mean by that. Our point is not to discuss the probability of far-right leader Mrs. Le Pen and far-left leader Mr. Melenchon becoming political allies. The “Le Penenchon” risk is the risk that non-mainstream/anti-market policies take the lead in the pre-election polls and potentially come to power.
One of the features of this year’s elections in France is that the battle lines have changed. In the past, the choice in French national elections was between mainstream left and right majorities, both – to a large extent – being supportive of EU membership and of a market economy. Of course, some readers outside of France may find that what we call in France “mainstream left” was more alike of Bernie Sanders and “mainstream right” more alike of Tony Blair, but the fact of the matter was that once in government, their policies remained quite predictable and relatively centrist – by French standards. This time, things have changed pretty drastically for several reasons. First, because the far-right National Front of Mrs. Le Pen has added a high-profile economic platform to its previously mainly anti-immigration and anti-establishment agenda, which has a lot in common with the far-left program – 35-hour workweek, lower retirement age at 60, scrapping of the recent labor market reform, increased social subsidies, larger budget deficit, protectionist regulation and tariffs, end of EU and Euro membership, monetary financing and end of CB independence, etc. Second, because the far-left candidate Mr. Melenchon has turned down its pro-immigration rhetoric and emphasized its anti-market economy agenda. Third, because the candidate for the “mainstream left”, Mr. Hamon, has been elected on an economic platform which has more in common with the one supported by Mrs. Le Pen and Mr. Melenchon than by the incumbent socialist government – except for the EU/euro membership topic. In other words, the “mainstream left” seems to have turned anti-market economy.
A nightmare scenario for markets
The bottom line is that among the 5 leading candidates for the presidential election, only 2 of them support market economy policies and EU/euro membership: Mr. Macron on the center left and Mr. Fillon on the right. Importantly, although the polls currently show each of those two winning in the second round against any of the non-mainstream candidates, a second round between two of the non-mainstream candidates is not impossible. That’s the “Le Penenchon” scenario, which could raise risk aversion through the roof; the possibility that the next French president drives the country’s economic agenda towards unchartered territories and grand experiments. More immediately, as the campaign unfolds, the rhetoric heats up and central scenarios change until April/May, we believe that risk aversion and market volatility may well rise significantly for French assets but also for European credit.
Overall, the “Le Penenchon risk” and its likes have the potential to become major tail events for European credit markets. Hence, our cautious deployment and portfolio positioning – low gross and net exposures, focus on short-duration, idiosyncratic and catalyst-driven stories, tail hedge. They may also trigger bouts of market dislocation in the aftermath where our dry powder can be deployed smartly and profitably. Whichever way political risk in Europe plays out in 2017 – let’s emphasize that we are not making predictions on any outcome here – we have to be ready.