French elections – the euro awakens
No surprise, but a new normal
The first round of the French elections can be read in two ways. First, there was no surprise. Indeed, the two winners have led the polls since January. A closer look at the details, however, shows something more profound.
For the first time in 40 years, neither of the traditional parties have made it through to the second round. It remains to be seen whether this represents a new normal for France. Indeed, with anti-establishment votes for the far left or right on a par with the more established parties, we have an unprecedented situation which is likely to weigh on the forthcoming legislative elections and on the political stability of France.
Risk aversion should decrease
For the financial markets, the adverse scenario of a Mélenchon/Le Pen second round did not materialise, shrinking the “tail risk” of a dislocation of the euro. We anticipate a significant reduction in implied volatility in the short term, as well as a depreciation of the yen, and have already started to see this happening in the markets.
This decline in risk aversion should also be reflected in a rebound in risky assets such as high-yield credit and equities and emerging currencies.
Fundamentals are back
If 2016 was all about political risks, it is starting to look as though that trend has peaked. The elections in the Netherlands and the first round of the French election have not produced the shock result that was feared. The risk of an exit of a founder country has been reduced, and we expect investors to focus again on macroeconomic fundamentals.
Already, the tightening of the yield spread between French and German government bonds from 71bp to 49bp reflects the perception that risk has fallen. This is good news for Europe. This is in addition to a favorable economic outlook. As our European nowcaster points out, cyclical improvement is clear and sustained in Europe.
This positive situation is likely to be taken into account by the ECB, which is expected to raise its growth projections in June and prepare markets for a reduction in unconventional monetary policy.
Against this relatively benign environment, we have reduced the protection put in place during the first round of the French election. Our dynamic allocation is anchored in an overweight in risky assets, in particular emerging European and Japanese equities, and a significant exposure to the euro in expectation of a change in the ECB’s discourse and a narrowing of the growth and inflation differentials between the two zones.
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