Populist wave likely to be stopped in France

A populist wave that swept through the United States and the United Kingdom is set to end in France, in our opinion. Far-right leader Marine Le Pen, though very likely to make it to the second round of presidential elections, will in all probability eventually lose out to a more moderate challenger this coming May. Even so, investors last year woke up to the reality that voters’ preferences remain unpredictable. This message continues to resonate in financial markets.

Last year’s decision by UK voters to leave the European Union and the election of Donald Trump as the 45th US President were clearly ground-breaking events that proved polls and pundits equally wrong. It is quite natural for the media in general and investors in particular to assign a serious probability of a victory for far-right politician Marine Le Pen in the forthcoming French presidential elections. As she is promising a referendum on France’s membership of the European Union and the euro, it is understandable that investors fret about the consequences of the Front National gaining power.

French economic woes push voters to extremes
Recent developments in European politics seem to suggest otherwise. The poor showing of the Freedom Party in the recent Dutch general election may be a sign that populism has lost some of its appeal. However, to predict the election result in France based on what happened in the Netherlands would be futile. While immigration issues rank high in both countries, the strong Dutch economy boasts almost full employment, in contrast to the dire situation of the French economy with an endemic, double-digit unemployment rate. France’s economic decline is pushing the electorate towards extremes, both on the right and the left. It is worth noting that the Front National’s economic programme echoes that of the French far left with respect to protectionism and nationalisation.

That being said, the French election system makes a victory of Le Pen a distant possibility. Although she is likely to pass the first round on 23 April, she will almost certainly be defeated in the second round either by Emmanuel Macron (En Marche!) or François Fillon (Les Républicains). Moreover, this would be by a substantial margin (see chart 1). Even if she prevails, the likelihood for her party to garner a majority in the National Assembly will be close to zero. It is very hard to imagine a path towards a referendum, even in an aggressive scenario.

As a result, we believe that assets shunned by investors for fear of yet another political surprise should recover – in particular euro-related ones – while “safe havens” such as German government bonds or the US dollar might come under selling pressure.

Trump administration’s initiatives bogged down
Turning to the US, market participants are increasingly questioning the new administration’s ability to implement the Trump agenda. Its recent failure to move Congress to repeal the Affordable Care Act, popularly known as “Obamacare”, dealt a serious blow to its credibility. Will the ambitious tax, deregulation and infrastructure initiatives be derailed as well? While it is too early to extrapolate, investors will certainly scale down their expectations. It is no wonder that equity, interest-rate and foreign-exchange markets have recently been directionless.

Chart 1: Centrist candidate Macron seen ahead of Le Pen in second round of elections

Source: IFOP, ELABE, Harris, OpinionWay, BVA, IPSOS, Kantar-Sofres, Odoxa, Wikipedia, Vontobel Asset Management

At the same time, the U.S. Federal Reserve (Fed) has made it clear that it plans to raise interest rates gradually, dampening fears of a more aggressive stance in light of a strong job market and core inflation close to its 2-percent target. Crucially, the Fed is not taking into account the Trump administration’s planned measures to boost the economy. It will only do so once such initiatives have taken the necessary hurdles, which appears to be the right stance given the Trump camp’s failure to “repeal and replace” the healthcare bill.

Changes in equity, bond and currency positions
We generally stick to a neutral equity allocation. Global economic momentum and corporate earnings revisions – the ratio of analysts’ earnings upgrades and downgrades – remain favourable. At the same time, elevated valuations and rising doubts about the Trump agenda cap the upside. Within the equity mix we have moved to an overweight stance towards the euro-zone as we believe investors place too high a probability on a Le Pen win.

As long as the Fed sticks to its gradual approach and the US anti-trade rhetoric does not lead to concrete action, the US dollar should continue to struggle against the euro. Besides, the latter currency is supported by euro-zone Purchasing Managers’ indices signalling reasonably strong economic momentum (see chart 2) for the period ahead. This is why we have removed our residual overweight stance on the US dollar as the upside and downside risks appear to be well balanced for now.

Apart from stacking up on euro-zone stocks, we have also increased our positions in emerging-markets bonds denominated in local as well as hard currencies. Their running yield compares well with fixed-income alternatives. Moreover, the risk of an overly strong US dollar or damaging import barriers (or both) imposed by the US has receded, which helps emerging-market assets as a whole.

Chart 2: Higher PMI readings suggest brightening prospects for euro-zone economy

Source: IHS Markit, Thomson Reuters Datastream, Vontobel Asset Management

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