French elections in focus but US data likely to draw attention

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February is ending with a whimper rather than a bang. Market pricing for a Fed hike in March continues to flirt with 5-6bp while in the UK the market seems to be waiting for the government to trigger Article 50. Meanwhile the ECB is likely to stay in a holding pattern until it knows what kind of French president it will be facing come 7th May.

US ISM, income, spending, and inflation data out on 1 March could however potentially move the needle on financial markets.

I continue to expect a 25bp Fed hike in March but acknowledge that this is a low conviction forecast at this stage.

In France, the latest headline-grabber is that veteran centrist politician François Bayrou announced on the evening of 22nd February that he had opted not to run for the presidency. He will instead lend his support to Emmanuel Macron, the independent centrist candidate of the En Marche! Movement.

This should have come as little surprise but markets still reacted positively, with in particular French bond yields sliding lower.

The justification for this admittedly modest market reaction is that Bayrou’s electorate will now transfer its votes to Macron, in turn increasing the probability of Macron coming ahead of François Fillon and making it to a second round run-off against Marine Le Pen.

There is some logic to this argument, as recent polls suggest. Moreover, the relatively inexperienced Macron may benefit from Bayrou’s familiarity with the ins-and-outs of campaigning gained over three previous presidential election bids.

But there is also some evidence that Fillon, the Republican candidate, may benefit from Bayrou’s decision and it is simply too early to predict with confidence whether Macron or Fillon will make it to the second round.

The bottom line is that Bayrou’s decision has increased the odds of Macron and to a lesser extent Fillon making it to the second round and further decreased the odds of Le Pen winning in the second round against either Macron or Fillon.

Meanwhile, time is running out for Socialist Party candidate Benoit Hamon to secure a second round place.

February ending with a whimper, but possible March bang

Uncharacteristically, there has been a dearth of events or data this week to really move the needle in financial markets. President Trump has been unusually quiet and State Secretary Mnuchin’s promise of forthcoming details about the government’s tax and infrastructure plans has failed to excite interest rate markets. Federal Reserve bankers have been queuing up to share their thoughts about US monetary policy but market pricing for a 15th March Fed hike continues to hover around 6bps while pricing for the full-year still remains just north of 50bp (see Figure 1). The market still clearly needs convincing that the Fed will move on rates just three months after its December 2016 hike, with pricing for a May hike a more substantial 15bp.

In the UK, it has now been 246 days since the British electorate voted in favour of the UK leaving the EU. With the government’s draft bill to allow it to trigger Article 50 still running its course in the House of Lords (upper house of parliament), the Brexit debate has lost some of its bite and may not reassert itself on markets’ psyche until the government formally announces, by end-March according to Prime Minister May, its intention to leave the EU.

Finally, French elections continue to provide a daily dose of modest excitement, as I detail below. But the ECB is likely to stand pat on policy rates and its quantitative easing program until it knows for sure whether it will be dealing with a pro-EU French president (Emmanuel Macron), a somewhat pro-EU president (François Fillon) or a president intent on getting France out of the eurozone and EU (Marine Le Pen).
olivier desbarres french politics figs 1 and 2

 

Fed March rate hike alive but hardly kicking

Unless one or more of the ten Fed FOMC voting members significantly deviates from script or President Trump’s administration puts some meat on the skeleton of its planned fiscal stimulus program, market pricing of Fed hikes is likely to tread water. US data out next week, however, may give markets pause for reflection as I argued in March Madness (17 February 2017). The final estimate of Q4 GDP is due out on 28 February and perhaps more importantly ISM manufacturing data for February and January figures for personal income, spending and PCE inflation are scheduled for release on 1 March.

Pricing for a hike could conceivably edge higher if US data show a further rise in ISM manufacturing and personal income, spending and CPE inflation tick higher. ISM manufacturing rose for a fifth consecutive month in January 2017 (to 56.0) – the first time since 2013 when it rose six consecutive months from June to 57.3 in November. Figure 2 shows a reasonably good correlation between the US ISM index and the cumulative change in the Fed policy rate. A rise in the ISM index in February would consolidate the case for a rate hike if not in March, at least in H1 2017.

Real personal income growth has slowed significantly in the past two years while there is evidence to suggest that household dis-saving has helped prop up consumer spending growth (see Figure 3), as I argued in Common theme of low wage growth (10 February 2017). A number of FOMC members have alluded to pockets of weakness in the US labour market and the more dovish members may well want to see greater stability in income growth before signing off on another rate hike. I continue to expect a 25bp Fed hike in March but acknowledge that this is a low conviction forecast at this stage.

olivier desbarres french politics fig3

 

French presidential elections – The election campaigns that keep on giving

The first round of the French Presidential elections will be held on 23rd April, with the likely second round on 7th May. But already there has been much drama, with a number of French political heavyweights not even making it to the first round. President Hollande opted not to run for a second term – the first time since the 1974 elections that an incumbent French President has not run for a second term – arguably making it trickier to rely on past elections as a guide to this year’s outcome. Prime Minister Valls was beaten in the second round of the Socialist Party primaries.

Moreover, François Fillon, the Republican candidate, is being investigated for possible misuse of public funds and the European Union is investigating the National Front, led by presidential candidate Marine Le Pen, for alleged misuse of EU funds. Distinguishing political noise from outcome-changing developments remains fraught with difficulty and there are still 58 days until voters go to the polls to elect France’s head of state.

The latest headline-grabber is that veteran centrist politician François Bayrou, who had yet to declare his candidacy for this year’s presidential elections, announced on the evening of 22nd February that he had opted not to run for a fourth time. Instead he will lend his support to Emmanuel Macron, the independent centrist candidate of the En Marche! Movement (see Figure 4).

Macron has accepted Bayrou’s offer, which comes attached with a few conditions, namely that if elected he would pass laws against conflicts of interest and introduce proportional voting in the lower house of parliament. Macron has been supportive of these proposals in the past so they are unlikely to prove a major stumbling block. Also, it is not inconceivable, in my view, that behind closed doors Bayrou will ask for a senior government position should Macron become the first centrist president since Valéry Giscard d’Estaing was elected in 1981.

Bayrou is the leader of the Democratic Movement and the Mayor of town of Pau. He has been polling about 5% in the polls for the first round of this year’s elections and was thus never going to have sufficient votes to even come close to making it to second round (see Figure 5). He is arguably coming to the end of his political career and his decision to support a potential future president is unsurprising. Bayrou’s allegiance has shifted over the years. He supported Francois Hollande in the second round of the 2012 elections, then last year switched his allegiance to Alain Juppé (who got knocked out in the second round of the Republican primaries in November) and is now backing Emmanuel Macron.

olivier desbarres french politics fig5

 

French bond yields main beneficiary of Bayrou’s decision to support Macron

European markets rallied in the wake of Bayrou’s announcement, although the gains in the euro and French equities were very modest and have since been reversed. The compression in French yields and spread with German bonds has arguably been more pronounced, with 2, 5 and 10-year spreads narrowing by about 4bp, 3bp and 4bp respectively in the past three sessions (see Figures 6 and 7). I would expect more significant moves in French and European financial markets as we inch towards an election denouement.

The justification for this admittedly modest market reaction and the media’s core argument is that Bayrou’s electorate will now transfer its votes to Macron, whose support had slid below 20% seemingly as a result of comments he made on 15th February about France’s post-war colonisation of Algeria and was slightly trailing Fillon (see Figure 5). This would in turn increase the probability of Macron coming ahead of Fillon and making it to a second round run-off against Marine Le Pen.

There is some logic to this argument. The latest polls by Ifop and Opinion Ways show that support for Macron has risen by respectively 3.5 and 1 percentage points since Bayrou’s announcement. Moreover, these two opinion polls are conducted on a three-day rolling basis and therefore the latest numbers include the results of polls conducted before Bayrou made his announcement. As these old data fall out of the calculations, opinion polls in coming days may show an even greater bounce in support for Macron.

 

Lower probability of Le Pen victory is the main take-away

But there are also some slight flaws in this thinking. First, it is not clear that Macron becoming president is more positive for European financial markets than Fillon becoming president. Both are pro-Europe although Fillon has admittedly pushed for deeper reforms of the European Union’s institutions and inner-mechanics. Fillon arguably has a more market-friendly policy agenda than Macron, having promised to cut taxes and cut social security benefits.

Second, Bayrou’s votes may also well help Fillon. While the latest poll by Opinion Ways shows support for Fillon stable at 21% since 22 February, Ifop’s latest poll shows a jump in support for Fillon of 1.5 percentage points to 20.5% Moreover, polling agencies BVA and Elab have in the past month conducted two sets of surveys – one with Bayrou as presidential candidate, one without – which suggest that Bayrou’s 5% of the popular vote will be split between Fillon (1.3%), Macron (1.3%), Hamon (0.8%), Melenchon (0.8%) and Le Pen (0.5%), as depicted in Figure 8.

olivier desbarres french politics fig8

Put differently, Fillon and Macron would each get 25% of the Bayrou vote in the first round, while Le Pen, who is pushing for France’s exit from the eurozone and EU, would only get 9%. With this in mind and given that Macron and Fillon are still each polling just north of 20%, it still too early to predict with conviction which of these two candidates will make it to the second round, in my view.

But, importantly, while Le Pen will still likely top the first round, whomever she meets in the second round (Fillon or Macron) will likely benefit more than she does from the Bayrou vote. Ifop and Opinion Ways have support for Le Pen flat-lining at respectively 26.5% and 26% since Bayrou’s announcement on Wednesday. Moreover, the gap in a second round head-to-head between Macron and Le Pen has increased to 22 percentage points from 20pp before Bayrou’s announcement according to both Opinion Ways and Ifop.

No new polls have been conducted for a Fillon-Le Pen duel. But if we scale up the first round numbers of votes that would have gone to Bayrou using the BVA and Elab polls – 9% of the Bayrou votes for Le Pen and 25% of the votes for Macron and Fillon – this translates into 27% of the Bayrou votes going to Le Pen in the second round and 73% going to Macron or Fillon. Based on a turnout of 37 million voters[1], that equates to about 535,000 extra votes for Le Pen but 1.4 million extra votes for Macron or Fillon. These simple calculations make certain assumptions, but the BVA and Elap polls suggest that Bayrou’s voters will swing support in favour of Macron or Fillon by a non-negligible 900,000 votes in the second round.

The bottom line in my view is that Bayrou’s decision has increased the odds of Macron and to a lesser extent Fillon making it to the second round and further decreased the odds of Le Pen winning in the second round against either Macron or Fillon and that is why ultimately the rally in European financial was justified.

 

So what now?

While Macron and Fillon may both benefit from Bayrou’s voters, Macron may arguably gain a further advantage from Bayrou’s explicit support for his presidential bid: Bayrou’s experience and familiarity with the ins-and-outs of campaigning. Bayrou is a veteran of three presidential elections, coming fifth in the first round of the 2012 elections with 9.1% of the popular vote, third in 2007 (18.6%) and fourth in 2002 (6.8%) – see Figure 9. Bayrou was also Minister of Education in 1993-1997, a Member of the European Parliament (MEP) in 1999-2002 and a National Assembly (lower house of parliament) deputy for nearly 20 years (in 1986-1993, 1997-1999 and 2002-2012).

Among the current top four candidates (based on the latest polls) – Le Pen, Macron, Fillon and Hamon – only Le Pen has run in a previous presidential election. She came third in 2012 with 17.9% of the popular vote and fourth in 2007 with 10.44% (see Figure 9). Macron, aged 35, is in comparison reasonably inexperienced, with his two-year stint as Economy Minister in 2014-2016 his only major political posting. I argued in EM currencies, Fed, French elections and UK reflation (25 November 2016) that “Macron may ultimately struggle in the first round as he does not have a powerful political machine behind him.” I would add that he has a limited territorial reach, with much of his electoral support concentrated in Paris and Lyon, a very small campaign team and still only a broad-brushed policy program.

This has been both a strength and weakness. One the one hand it has boosted Macron’s anti-establishment credentials at a time when electorates in France (and other developed countries for that matter) are pushing back against the large, well-established and well-funded Republican and Socialist parties. On the other hand it is handicapping Macron’s ability to reach out to grass-root voters across France, with Fillon, Hamon and Le Pen enjoying the backing of parties with a wide and deep political reach.

At the same time support for François Fillon, which fell in January due in large part to the investigation in his alleged misuses of public funds, has seemingly stabilised. I would argue that the closer we get to the first round, the less likely it is that evidence against Fillon will be put forward and that he pulls out of the presidential race. If that is the case and focus on Fillon’s financial dealings subsides, he may well be in a position to start rebuilding his support which averaged about 25% in January.

 

Time running out for left-wing candidates to secure place in second round

For the past year the over-whelming consensus view, shared by the media, political commentators, analysts and betting companies, has been that the Socialist Party candidate simply stands little or no chance of making it to the second round, let alone becoming president. Benoit Hamon’s surprise victory in the Socialist Party primaries in January over former Prime Minister Vals has seemingly done little to change this perception.

The main argument is that the Socialist Party is tainted by President Hollande’s weak presidency and former Prime Minister Valls’ fall in popularity and that more generally left-wing parties, including in the UK (Jeremy Corbyn’s Labour Party) and US (Democrats) have fallen out of favour with electorates. This is seemingly borne out by recent opinion polls for the first round, with Hamon in fourth place with about 14% support.

Hamon currently trails Macron and Fillon by about 9.5 percentage points and 7.5 percentage points, respectively and if anything support for Hamon has sliped slightly since Bayrou’s announcement. Jean-Luc Mélenchon, the leader of the Unsubmissive France movement is an even longer shot, currently in fifth place with just 11% support.

Moreover, Mélenchon has categorically excluded the possibility of dropping out of the race and offering his support to Hamon’s presidential bid. Yannick Jadot, the leader of the Green Party, announced yesterday that he would not to run for president and instead support Hamon’s presidential bid. However, this is unlikely to have a material impact on the probability of Hamon making it to the second round with popular support for Jadot a negligible 2%. So while it may be premature to fully write off the possibility of Hamon coming second on 23rd April, time is slowly running out for him to close the gap with the three front-runners.

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

 


[1] Turnout in second round of the 2012 and 2007 presidential elections was respectively 37.34 million and 37.02 million

 

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