French presidential elections: “Don’t panique !”

EXECUTIVE SUMMARY

• Is the market underestimating the risk of a surprise outcome in the French elections? Unlike 2017 the delicate phase for investors lies between the first and second round. A significant repricing of the political risk premium could occur in case we see (i) a massive shift in second-round voting intentions against incumbent Emmanuel Macron and/or (ii) a risk of massive abstention.
• Our base-case scenario is a victory of incumbent Emmanuel Macron with a repeat of the 2017 contest against Marine Le Pen in the second round. We expect some temporary spread widening for French government bonds (OAT) between both rounds. However, a victory of an EU-skeptical candidate would carry longer lasting risks for both OAT and peripheral spreads.
• French government bonds’ semi-core status is not a given and will depend on France’s relative fiscal stance in the Eurozone. While the budget deficit doesn’t show noticeable improvement from the pre-Covid-19 years (-6.5% in 2021, -7% for in 2022) none of the candidates’ programs point to a consolidation course.

Is current market pricing underestimating the risk of a surprise outcome in the French elections?

The upcoming Presidential elections in France are taking place in a very different context compared to that seen during the previous elections in 2017. That year marked a peak of political uncertainty in Europe as volatile polls suggested that two EU-skeptic candidates (M. Le Pen and J.L. Mélenchon) had a non-negligible chance of being elected. The possibility of a sovereigntist shift in Europe’s second-largest economy fueled concerns about EU cohesion and even reignited Euro exit fears. The EUR depreciated -5% vs the USD and the risk premia of French government bonds (OAT) increased significantly, reaching the highest value since the Euro crisis in 2012 (Figure 1). Today, despite the recent increase the risk premium of French government bonds remains contained. Europe has become more fiscally integrated with the Covid-19 crisis, and the invasion of Ukraine has reinforced foreign policy, defense, and energy cooperation.

Figure 1: Risk premium of French government bonds (OAT) around elections 10y OAT versus 10y Bund, in bps

Polls give incumbent Macron a lead of 7pp in the first round which translates into 99% probability of reaching the second round (given a 3% margin of error and 95% confidence). In the second-round polls his margin is still sufficiently high for a likely re-election. But in a contest with Marine Le Pen (which is by far the most likely outcome) the recent trend evolves against him. The gap has narrowed to 3-5 ppt. But if the 3% margin of error is accurate that implies a 85% to 95% winning probability. (Table 1).

Table 1: Probability tree for 2022 Presidential elections based on latest poll data

The biggest potential for a surprise lies in a possible misrepresentation of voting intentions by the polls. This risk is significant in the second round in case of a strong asymmetric mobilization of the electoral base, be it by non-voters starting to vote or usual voters discouraged by the remaining choice of candidates. In Figure 2, we depict the current polls for a Macron-Le Pen second round. Given the expected abstention and voter flows from eliminated candidates, the outcome still puts Macron in the winning position. To push the outcome to the other side of the victory line, Le Pen would either need to increase her voting share to 48% of the total electorate (with unchanged mobilization for Macron) or the mobilization of Macron’s potential electorate would need to fall below 40% with an unchanged voting share for Le Pen (Figure 2).

Figure 2: Risk of asymmetric mobilization in the second round

Two factors determine whether the political risk premium should be repriced to the upside: (i) a massive shift in second-round voting intentions against Macron and/or (ii) a risk of massive abstention. We see the latter as the greater risk especially in case of a repeat of the Macron-Le Pen duel may weaken mobilization, notably among left-wing voters. Unlike in 2017, the delicate phase for investors lies between the first and second rounds, not ahead of the first.

No divergence between prediction markets and poll-implied probabilities.

A good indicator of rising uncertainty is the divergence between poll-implied probabilities and prediction markets. In 2017, prediction markets priced in a significantly higher winning probability for Marine Le Pen, reflecting heightened skepticism about accurateness of polls after the surprises of Brexit and the US presidential elections. We do not observe the same pattern today. Prediction markets and polls are still broadly aligned, giving Macron the favorite position (Figure 3). In 2017, the probability of Le Pen being elected was 30% higher in prediction markets. The divergence is smaller today (15%) but rising (Figure 4). However, this increase should not be overestimated. Increasing trading activity and shifts in prediction pricings is typical for the late phase of an election campaign.

Figure 3: Implied probability of winning

Figure 4: Deviation of prediction markets vs polls

We expect a limited the impact of the French elections on capital markets
From the current polls and prediction markets, we derive four different scenarios (Table 2) that we translate into capital markets scenarios (Table 3).

Table 2: First and second round scenarios

Table 3: Translation into capital markets scenarios

The main driver behind the differences between our scenarios is not specific to France but related to the perception of further European integration. Contrary to 2017, the tail risk of a Frexit (i.e. Euro exit and currency redenomination) can be excluded. Even the most EU-skeptic candidates have renounced that option. However, tensions with EU institutions are not off the table. The victory of an EU-skeptic candidate could still undermine European integration and weaken Europe’s capacity to respond to a crisis. Therefore, the scenario of a potential populist presidency would still carry risks for both OAT and peripheral spreads as broader-based fragmentation risks are repriced in the medium term.
For French government bonds, we see the following market reactions:

• Upside scenario [green]: Macron and Pécresse in the first round could marginally tighten OAT spreads (-5bps) as markets would price out some EU-skepticism.
• Base-case scenario [blue]: A repetition of the 2017 contest between Le Pen would trigger some OAT spread-widening ahead of the second round (+15bps), especially if abstention becomes a problem. But with a win for Macron standing for continuity in both economic and foreign policy, this increase should prove transitory.
• Adverse scenario [yellow] & Worst-case scenario [pink] : A far right or far left victory could widen OAT spreads in the medium-term as their election would entail higher uncertainty on economic (larger deficits) and foreign policy (tensions with the EU). A defiant attitude towards the supremacy of EU law over national law could be mostly concerning to investors, putting longer-lasting pressure on OAT spreads (+50bps to +90bps).

No matter who wins, France’s fiscal deficit is heading towards a new record high.

Compared to its peers, France’s fiscal policy has already been on the expansionary side of late.  Ahead of the Presidential elections, the government increased fiscal support to households (EUR22bn fuel subsidies to cap gas prices) and corporates (at least EUR3bn) through the “Resilience Plan”. We estimate that in total the measures for households should support disposable income by +1.4pp while the corporate support is equal to +0.7pp of gross operating surplus or +0.2pp of additional margin. In addition, the government implemented liquidity measures, such as the rescheduling of employer’s social contributions and additional state-guaranteed loans of at least EUR60bn in additional cash-flow (on top of the EUR204bn of corporate excess savings accumulated during the Covid-19 crisis, as of January 2022).

In this context, France’s budget deficit is likely to exceed -7% of GDP in 2022 (after 6.5% of GDP in 2021), without a noticeable improvement from the pre-Covid-19 years. Despite strong public support to households, rising energy prices will take a toll on consumption in France. Hence, we expect economic growth to reach +3.0% (-1pp) this year and +1.5% (-0.4pp) in 2023. In the long run, we expect GDP growth to average +1.5%, almost at par with its potential.

The programs of all the main candidates are expansionary and should increase the fiscal deficit further. The total net costs go from 8.7 as a percentage of GDP in the case of J.L. Mélenchon, –1.3 for E. Macron and –0.8 for V. Pécresse (Table 4).

While most candidates focus on purchasing power, one cannot exclude the risk of a policy deadlock. After a likely victory in the presidential election E. Macron could indeed fail to secure the majority in the Parliament in the legislative elections next June. This is clearly increasing social risks later in the year, in an environment where households’ real purchasing power is expected to decline for the first time in 10 years in 2022. A political deadlock would also make it difficult for E. Macron to implement the pension and employment reform which is expected to finance the tax cuts planned for households and corporates (i.e. EUR15bn).

Table 4: Economic plans for main candidates in the Presidential elections*

French OAT (semi-)core status is not in question for now but not secure in the long term.

Except in the case of Mélenchon, these additional deficits would not jeopardize France’s semi-core status among Eurozone issuers in the short run (max 60bps risk premium over 10y Bund). But they will not make it easier to maintain either, especially with developed market rates rising away from ultra-low/negative levels. With German Bunds back in positive territory, the need for investors to buy peripheral or semi-core bonds at positive yields for carry and/or duration extension is reduced. This shift in demand coincides with rising net issuance in 2022 as governments try to secure cheaper funding terms ahead of the ECB concluding its asset purchases. Besides the Presidential elections, the outlook on OATs is tilted towards higher rates and spreads for the moment. In the longer run, the OAT spread should be less driven by political risk and more by the perception of specific default risk. This will largely be influenced by the relative fiscal situation of France. Consolidation does not seem to be on the cards for now. But it could become an issue later in the term. In a deadlock scenario (E. Macron elected but without parliamentary majority) we expect a 10bp additional risk premium on 10y OAT. Instead of evolving in 30-50bps range, the spread might shift to 40-60bps range instead (Figure 5).

Figure 5: Decomposition of OAT risk premium (10y vs Germany, in bps)