Market nerves in anticipation of the French presidential elections in April and May 2017 have driven a spike in 10-year French and Italian government bond spreads, which have climbed 30 to 40 basis points (bps) in recent weeks (to 75 bps and 195 bps over bunds, respectively).
Fueling investors’ unease was a series of surprises on the French political scene, including right-leaning François Fillon’s unexpected victory in the centre-right Republican Party primary (and his quick loss in the polls thereafter), along with the election of left-leaning Benoît Hamon in the Socialist Party primary.
Le Pen’s chances unnerve investors
These election upsets have contributed to investor unease about the possibility that the far-right Front National party’s Marine Le Pen could become the next French president. Le Pen’s election manifesto, released on 4 February, clearly states her intention to eject France from the euro and to call for a referendum on EU membership. And while Le Pen will likely fall far short of an absolute majority in the June parliamentary elections, which would tie her hands in this regard, her election would still be a significant event likely to spook the markets.
We think the chances of Le Pen becoming president remain contained. While she may well gather the most support in the first round of voting (see chart), we believe she is unlikely to succeed in the second round, when moderate voters have historically coalesced against Front National candidates.
That said, we would not dismiss the possibility outright, for several reasons. First, Le Pen’s main rival (and currently the favorite in the election race), centrist Emmanuel Macron of the self-created En Marche! party, is a relatively new entrant to the political scene, and the stability of his support is questionable. Second, while Le Pen would most likely lose to Macron in the second round of voting, polls suggest it would be a tighter race against Fillon and a knife-edge contest against left-leaning candidates Hamon or Jean-Luc Mélenchon. And third, the current political environment has proven highly unpredictable, as evidenced by the UK vote to exit the EU and the election of Donald Trump as the U.S. president.
In the face of election-related uncertainty and rising political risk, we favor conservative positioning of our portfolios in Europe. While French and Italian government bonds have already sold off, they could lose further value heading into the French election and amid lingering political uncertainty in Italy. Moreover, we are positioned defensively in European corporate credit, given that corporate spreads are near historical lows and the payoff in the current environment appears negatively skewed.
Nicola Mai is a PIMCO portfolio manager and leads sovereign credit research in Europe. Philippe Bodereau is a portfolio manager in London and global head of financial research. Eve Tournier is head of pan-European credit portfolio management.