French elections and financial markets: what would an extreme scenario look like?

By Julien-Pierre Nouen le
The opinions expressed in this document are valid as of April 2017 but are subject to change.

What influence will the French presidential elections have on financial markets? The impact will most likely be limited. As long as policies stay away from the extremes, financial markets tend to react more to the economic backdrop (growth and inflation) and trends in corporate earnings prospects. Currently, opinion polls suggest the second round could pit Front National (FN) candidate Marine Le Pen against Emmanuel Macron or, with a lower probability, against François Fillon. Either Macron or Fillon would almost certainly beat Le Pen, which means that the next President of France could be Macron or Fillon – two candidates who have both expressed their intention to reform France, albeit with different approaches. Yet alongside this fairly positive central scenario, we must also consider the possibility of Marine Le Pen being elected, even though the probability is, in our view, very low.

Introduction

Would Marine Le Pen’s election pave the way for France leaving the euro zone? While Marine Le Pen’s public comments have been cautious, leaving the common currency is a structural part of the FN’s programme. Exiting the euro would trigger a redenomination of a large number of assets in French francs. This new French franc would be hit by high inflation and probably face great distrust from investors, reflected in high interest rates. However, assuming Marine Le Pen were elected, we believe that she would be unlikely to deliver on her campaign promises due to various reasons that we will describe below. Nevertheless, an electoral victory for Le Pen would sharply increase the probability of this “Frexit” scenario, ushering in a period of uncertainty and high volatility on the markets. This would prompt us to revise our allocations.

What if Marine Le Pen were elected?

Membership of the euro zone is a requirement of European Union (EU) treaties, and Article 88 of the Constitution of the French Republic states that France is part of the EU. A constitutional amendment would therefore be required before France could exit the EU and withdraw from the common currency. Article 89 of the French Constitution defines the conditions for constitutional amendments. Either a proposed amendment must be approved by a three-fifths majority of both Houses of Parliament convened in Congress, or it must be passed (in identical terms) by both the National Assembly and the Senate with a simple majority, and then approved through a referendum. Even assuming that the FN won a majority of seats in the National Assembly, the indirect suffrage method for electing Senators would prevent the constitution from being amended this way.

With Article 89 ruled out, another strategy would be possible based on Article 11 of the Constitution. This strategy would actually involve two different referendums: an initial referendum would amend the Constitution so that a second referendum could be organised more easily. This second referendum would deal specifically with EU membership. Article 11 on legislative referendums stipulates: ”The President of the Republic may, on a recommendation from the Government when Parliament is in session, or on a joint motion of the two Houses, published in the Journal officiel, submit to a referendum any government bill which deals with the organisation of the public authorities, or with reforms relating to the economic, social or environmental policy of the Nation, and to the public services contributing thereto, or which provides for authorisation to ratify a treaty which, although not contrary to the Constitution, would affect the functioning of the institutions”. The reference to “the organisation of the public authorities” gives rise to an ambiguity that Charles de Gaulle exploited on two occasions: in the 1962 referendum that adopted universal suffrage for electing the President of the Republic, and in the 1969 referendum to reform the Senate (the proposed reform was rejected in this referendum). On both occasions, the Constitutional Council, faced with a fait accompli, ruled that the referendums were constitutional due to the primacy of the people’s will, as expressed through the vote. However, the legal footing for such a strategy is uncertain; hence, all other constitutional reforms since then have been based on Article 89.

The measures that the Front National would like to include in this constitutional reform notably include proportional representation for the National Assembly, with a majority bonus system, and a repeal of the limits to Article 11. Thus, Marine Le Pen could use the amended Article 11 to change the Constitution and exit the EU. Article 11 provides that the referendum is held ”on a recommendation from the Government when Parliament is in session”. However, the current session has been closed since the end of February because of the forthcoming elections, and will not reopen until a few days after the parliamentary elections. The President can summon the Parliament for an extraordinary session, but then which government would take action? Even if Marine Le Pen were elected, it is highly unlikely that she would win a majority in the National Assembly. However, she would still have the means to act. After being elected, she would appoint a prime minister, who would form a provisional government. Traditionally, when a new government is formed, the prime minister gives a speech setting out the government’s general policy, and a vote of confidence is held. However, this vote is merely a republican tradition, and is not a requirement for the government to act within the scope of its powers. After the session is opened, this provisional government could propose a referendum. Article 11 provides that the government shall make a statement before each House, followed by a debate. MPs opposed to the referendum would file a censure motion, but there would be 48 hours between the time the motion is filed and when it comes up for a vote. This would leave the President of the Republic enough time to launch the process for holding the referendum.

If this constitutional reform were adopted, Marine Le Pen could proceed with organising a second referendum on euro zone membership.

She would then have to convince the French people that withdrawing from the euro is the right decision – bearing in mind that the latest surveys show that three-quarters of the population is opposed to leaving the euro zone. In short, it is undoubtedly an exaggeration to claim that a victory for Marine Le Pen would automatically mean France leaving the euro zone.

What impact on financial markets?

The increased risk of a euro zone exit following a hypothetical electoral victory for Marine Le Pen would automatically trigger market price adjustments and probably very high volatility as the political events described above unfold. As noted above, an eventual withdrawal from the euro zone would be a multistage scenario, and the markets might not fully price in this scenario until several steps had been taken, especially if the European Central Bank (ECB) intervened. Nevertheless, the magnitudes seen during the 2011 euro zone crisis provide an idea of the overall fluctuations that could result from such a scenario.

Interest rates for French debt would price in a greater risk of redenomination. It is quite likely that the peripheral countries would also be affected, as the long-term survival of the euro without France could be in doubt. In 2011, when investors were worried about Italy and Spain remaining in the euro zone, the Italian/German and Spanish/German bond spreads spiked to more than 500 basis points (see Figure 1).

The ECB’s stance would therefore be decisive. In the scenario described above, the ECB would initially endeavour to contain the damage by increasing its securities purchases as part of its quantitative easing programme or, at a minimum, by postponing any tapering. Short-term rates would decline sharply, as would German Bund yields, which would probably return into negative territory. In this context, the euro would depreciate considerably against the dollar. If France were the only country to suffer from market uncertainty, then the ECB might consider carrying out OMT1, although this would require implementation of an economic adjustment programme that the government would have to agree to.

In such a scenario, risky European assets would come under pressure. In 2011, as Italian spreads widened from around 140bps to more than 500bps, the maximum decline in the Euro Stoxx index was more than 30% (see Figure 2). Over the same period, the spreads on high-yield bonds doubled to 800bps. Financial stocks would certainly be the first to come under pressure.

It is also likely that deposit holders and investors would attempt to take their capital out of France. What would be the French government’s capacity to set up capital control mechanisms? It would probably be limited. Article 63 of the Treaty on the Functioning of the European Union (TFEU) stipulates that ”All restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited”. Therefore, any decree implementing capital controls would rapidly be declared invalid.

Capital controls were implemented in Cyprus in 2013 and in Greece in 2015, but these controls were approved by the European Commission on the basis of Article 65-1b, which authorises Member States ”to take measures which are justified on grounds of public policy or public security”. At the time, the very survival of the Cypriot and Greek banking systems depended on such controls. Therefore, capital controls could not be implemented until French banks hit a severe liquidity crisis. Given French banks’ current strength and the ECB’s likely reaction, such a situation would not occur for several months.

Could a Le Pen government attempt to use Article 65 to force through capital controls? Probably not, for two reasons. First, paragraph 3 of this article stipulates: “The measures and procedures referred to in paragraphs 1 and 2 shall not constitute a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments as defined in Article 63”. Second, on a political level, setting up capital controls would probably have a very negative impact on the FN’s chances of winning a majority in the National Assembly or of winning a referendum.

Conclusion

As the episode of Donald Trump’s immigration decree has shown, the very purpose of the rule of law is to limit governmental power and subject it to judicial review. The path that would lead France to exiting the euro zone is a very narrow one. Indeed, markets have been pricing in a lower likelihood of this risk in recent weeks (see Chart of the Week No. 13). Nevertheless, if such a scenario were to become more likely because of an electoral victory for Marine Le Pen, we would adjust our allocations accordingly, while maintaining our focus on the fair valuation of risk by the markets.

(1) Under Outright Monetary Transactions (OMT), the ECB intervenes on the secondary sovereign debt markets to purchase bonds issued by Eurozone Member States. This programme, which can only involve a single country, is based on acceptance of an economic adjustment programme.

The opinions expressed in this document are valid as of April 2017 but are subject to change.

This document is not pre-contractual or contractual in nature. It is provided for information purposes. The analyses and descriptions contained in this document shall not be interpreted as being advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.

 

 

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