The French presidential election, which takes place in two stages in April and May, is among the most uncertain in recent years and holds important implications for financial markets.

A major cause for concern in the markets is that the candidate currently leading in the polls for the first round of voting on April 23 is Marine Le Pen of the Front National Party. Le Pen is proposing policies that would mark a radical departure from current European mainstream politics. Among Le Pen’s proposals are several inward-looking policies that range from withdrawing from some free-trade agreements to restoring border controls, all of which conflict with key European Union (EU) principles.

The most sensitive topic for global financial markets, however, is her call for a French referendum on the euro, with a view to exiting the common currency and introducing a national currency. These proposals are so different from established mainstream European political thinking and policy direction that her election would pose a systemic risk to financial markets, as discussed in a recent article, Portfolio Positioning Ahead of the European Elections, by my colleagues Alessio de Longis and Jesse Hurwitz.

How the French Electoral System Works

The election system in France has two stages. In the first stage, several candidates compete to qualify for the second round. Only the top two candidates qualify for the second round1, which takes place this year on May 7. The candidate who wins more than 50% of the votes in the second round is elected president.

The two parties that have dominated the French political system for decades are the Socialist Party on the left and Les Republicans (or its predecessors) on the right, but several other parties also compete and have seats in the parliament.

The Main Candidates

In addition to Front National’s Le Pen, the current leader in the first-stage polls at 25%-27%, the other major candidates are:

  • Emmanuel Macron, founder of his own progressive political movement, En Marche!, and formerly of the Socialist Party – A former economy minister, Macron is not a career politician and is seen as centrist and a reformer. Macron has polled a close second to Le Pen over the past few weeks and has upward momentum. In some recent polls, he was tied with Le Pen.
  • Francois Fillon, Les Republicans – Former Prime Minister and former front runner Fillon is the center-right candidate. He is fast losing credibility and his position in the polls is deteriorating after a scandal regarding payments to his wife and children of hundreds of thousands of euros of taxpayer money for jobs they may not have performed. He is currently under “formal investigation,” which is not a confirmation of wrongdoing under French law but means investigators have reasonable grounds to pursue the matter. Fillon denies any wrongdoing and says he will not drop out of the race, though the pressure on him to do so is mounting.
  • Jean-Luc Melenchon, Parti de Gauche (Left Party) and Benoit Hamon, Socialist Party – Currently Melenchon (polling around 10%) and Hamon (polling around 15%) are splitting the vote on the left. If they join forces and agree to unite behind a common candidate, they may credibly compete for the second round of the election, but that appears unlikely.

Based on recent polls, Le Pen, Macron or Fillon would qualify for the second round. Polls suggest that either Macron or Fillon would win over Le Pen, by margins of about 20% and 18%, respectively.

The View from Inside France

I recently visited France to get a more informed perspective about the various issues and candidates, and had a chance to speak with local analysts, economists, economic advisers to the leading candidates, corporate leaders, and journalists.

My conversations with these political observers and analysts suggested that they believe the outcome will be similar to what the polls are indicating and that voters ultimately will coalesce behind the centrist candidate in the second round, as they have in the past.

In a similar race in the 2002 presidential election, Le Pen’s father, Jean-Marie Le Pen, then leader of Front National, progressed to the second round but lost to Jacques Chirac, who won more than 82% of the vote. And heading into last year’s regional elections, Front National ranked first in several races, including regions where it is particularly strong, but lost all of them in the second round against centrist candidates.

The current trend line, therefore, points to a centrist candidate victory, with a Macron presidency seeming likely as of now.

Why Markets are Nervous

If the trend line is indicating that a centrist candidate will win the French presidency, why are the financial markets so nervous about this election Several reasons:

  1. The possibility of a low-probability/high-impact event, specifically that Le Pen may emerge victorious. Her stated policies are so radical that her election would be a major disruption to the economy, the markets and Europe’s post-WWII consensus.
  2. After two unexpected results last year – Brexit and the U.S. presidential election – people have lost faith in polls and trend line scenarios.
  3. There have been a couple of surprises and twists in the story regarding the centrist candidates. Fillon was not a front runner before the Les Republican primaries but won unexpectedly. He led in the polls and, for a while, was seen as the likely future president. Then the scandal broke, and today his candidacy remains at risk. He has prevailed thus far but his ranking in the polls has suffered. Macron is new and somewhat untested in politics. He doesn’t have traditional party machinery behind him to mobilize the voters on election day, so voter turnout may be an issue.
  4. A few weeks ago, markets were concerned that the two left parties would unite and be competitive. However, markets feared that Le Pen would do better against a coalition that would likely be fairly left of center.

All of this is arguably too much for the markets’ taste.

Can We Trust the Polls?

Despite concerns about the reliability of the polls, they are still the best tools we have to predict election outcomes and have proved reasonably accurate in the past. It is important to understand that statistical tools are not perfect and do have margins of error.

For example, while Brexit was certainly not indicated by the markets’ or our trend lines, the polls were neck and neck and, one week before the referendum, several polls actually predicted Brexit, though the gap closed again in the last week. The market consensus was built despite the closeness of the polls, and that added a layer of judgment.

In the United States, presidential election polls accurately captured the popular vote results, but indeed missed some of the swing state outcomes.

In the French election, however, the polls currently predict the margin of victory for a centrist candidate in the second round will be 15%-20%. That makes it seem very unlikely Le Pen will win. However, the active portion of the campaigning is just beginning and, if the polls get tighter, election outcome scenarios and the risk profile for the markets may change. We will continue to monitor the polls.

Our Baseline Scenario

Our current baseline scenario, based on the latest polling data, is that a centrist candidate will win the second round and become the new president of France. At this point, the polls indicate it is likely to be Macron, but a Fillon victory would yield similar results. In both cases, the systemic risk would be avoided and France would be led by a relatively reformist president.

If the baseline holds and a centrist candidate wins, it is Goldilocks time for the Eurozone economy. The political and economic uncertainty would be over. Meanwhile, the European economy continues to perform well, as my colleague Hemant Baijal and I discussed previously in Keeping Tabs on ECB Meeting and Eurozone Economy.

Since then, EU confidence indicators have posted multiyear highs and the unemployment rate is at its lowest level since the global financial crisis.

In fact, European Central Bank president Mario Draghi’s summary of progress in the European economy is in line with our thinking. The recovery in the Eurozone broadened further across sectors and countries, and financial conditions improved.

The list goes on, but the key here is that tail risks such as deflation and redenomination risk are significantly reduced. The Eurozone still has challenges, including low core inflation and large debt stock in several countries, but clearly there is progress toward normalization.

Investment Implications

The combination of the removal of key political risk, an economy performing well, and higher inflation and nominal growth is, in our view, a good recipe for corporate bonds and equities in Europe.

We remain cautious about French election risk and have reduced our overall risk via underweights or active shorts in countries such as Spain and Belgium that may be severely affected if Le Pen wins and where valuations are currently rich. This positioning is in line with our baseline thinking as well. We anticipate higher interest rates in the United States, and higher inflation and gradually increasing long-term rates in the Eurozone, where we keep underweight positions in the International Bond Fund.

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1If one candidate gets 50% or more of the vote in the first round that candidate is elected. That has never happened