Tracking Frexit fears: Overblown or underestimated?

Investors are on alert for French election risk. It’s a medley of scandal, gaffes, and general uncertainty which is spooking markets as polls show Marine Le Pen and Emmanuel Macron neck and neck in the first round of what is one of the most unusual French elections in modern history. French spreads are largely tracking Le Pen’s chances of securing the presidency.

The scenario may be unlikely, but it is not impossible for Marine Le Pen to win this election. We currently assign an 85% probability of Le Pen losing the presidency with our base case being that either Macron or Francois Fillon will take the presidency. Nevertheless, we consider the 15% alternative: Le Pen wins the French presidential election.

In the wake of her shock win, market volatility would surge. She may first call a European Summit and make nationalistic demands to the European Union (EU) but such demands would not likely be well received. While she has threatened a referendum on EU membership, support from the parliament would not likely legitimise any such vote. Even so, the threat of EU/eurozone breakup would be be quite real as the eurozone’s second largest economy and founding nation could stumble toward Frexit.

Therefore, a Le Pen victory would likely result in a spike in sovereign credit spreads across much of Europe, as negative sentiment spills over into vulnerable periphery markets.  On the other hand, if Macron or Fillon were to win, then we would expect French sovereign spreads to fall roughly 30 bps, as the expectation of economic reform would raise potential output growth.  Any spike in spreads is likely to present alpha opportunity in either France or related markets once the election outcome is known.

Rebecca Braeu – Standish, a BNY Mellon company

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