The end of the European Union?

Geopolitical risks in Europe have been at the forefront of investors’ minds ever since the United Kingdom (UK) voted to leave the European Union (EU) in an unexpected decision in June 2016.

French Presidential Election

21 April 2017

It is evident that right wing parties have gained support in the region over a prolonged period of high unemployment, low growth and growing concerns about terrorism and the influx of migrants. Brexit was a clear example of the unrest in Europe and raised serious questions about the potential for similar referendums in countries including Italy, France, the Netherlands, Sweden and Denmark. More importantly, it raised questions over the possibility of an EU collapse.

The stability of the EU has faced a number of tests since Brexit, with the most influential to date being the Dutch general election in March this year. Right-wing populism hit a setback though with Geert Wilders, the anti-Islam and anti-EU candidate losing to the liberal incumbent Prime Minister, Mark Rutte. Whilst a result in either direction would have had little impact on the European economy as a whole, the result provided an important signaling effect and did not add fuel to the flame that is the populist movement in Europe. The next test for populism, and the biggest challenge to the stability of the EU and financial markets is the French Presidential election with the first round being held on the 23rd of April and the second round on the 7th of May. Global equity markets don’t appear concerned though, with the likes of the S&P 500, FTSE 100, DAX 30 and CAC 40 trading close to historical highs. We believe that markets are being too complacent about the possibility of a populist victory in France, and are underestimating the risks to the EU and the potential damage to investor sentiment.

What are opinion polls telling us?

France uses the two round voting system whereby a candidate requires more than 50% of the votes in the first round to win the Presidency. If this is not achieved, the top two candidates from the first round move on to the second round where they square off against each other, and the candidate with the most votes in the second round is declared victor. Given there are eleven candidates running for the Presidency, we expect the election to move into the second round. First round polls also indicate that no single candidate will be able to attain at least 50% of votes in the first round. First round polls have tightened in the lead up to the election, with Emmanuel Macron leading Marine Le Pen, followed by Francois Fillon and Jean-Luc Melenchon who is staging a late surge. More importantly, second round polling indicates a convincing victory by Macron in a run-off with Le Pen, as well as a victory by Fillon in the case of a run-off with Le Pen. If we consider that opinion polling for both the UK referendum and the U.S. Presidential election failed to predict their outcomes, and the high level of undecided voters in France, investors should not underestimate the possibility of a Le Pen victory.

Figure 1: First round voting intentions indicate a close race

Source: Bloomberg French election poll tracker 2017

Figures 2 and 3: Second round voting intentions in a Macron-Le Pen run-off or a Fillon-Le Pen run-off indicate a Le Pen defeat in either instance

Source: Ifop-Fiducial 2017

Figure 4: Profiles of the leading candidates

CandidatePartyPolitical IdeologyView on the EUAgenda/ Views
Marine Le PenNational FrontFar-right populistLeave
  • Renegotiate relationship with the EU or a possible withdrawal
  • Protect public workers. French workers to get priority
  • Reduce the retirement age
  • Greater cooperation with Russia
  • Critic of NATO
  • Cut immigration and reinstate border controls
Emmanuel MacronEn Marche! (On the Move)Socially liberal centristStrengthen the EU
  • Reduce corporate and wealth tax
  • Reduce public spending and public jobs
  • Favours strong external EU borders
Francois FillonThe RepublicansCentre-right conservativeStay
  • Opposes borderless travel in the EU
  • Reduce public spending and reduce public jobs
  • Quota limiting number of immigrants
Jean-Luc MelenchonLa France Insoumise (France Unbowed)Far-leftLeave
  • Renegotiate relationship with EU or a possible withdrawal
  • Increase public spending
  • Reduce the retirement age
  • Reduce lower income taxes and raise higher income taxes
  • Critic of NATO

Why is a Le Pen victory a concern?

Even though Le Pen’s chances are small, they are not negligible. Of greatest concern to the stability of financial markets is Le Pen’s pledge to restore sovereignty by way of renegotiating with the EU, and holding a referendum on EU membership. We believe that the risk to the EU is being underestimated. A Le Pen victory is not analogous to the outcome of Brexit given that the largest net contributors to the EU budget are now in the process of leaving the EU (eg. UK), or have the potential to leave the EU (eg. France).

Financial markets should be pricing in a greater possibility of an EU collapse

A victory by Marine Le Pen would intensify concerns of an EU collapse, and this would damage investor sentiment as well as stall business and investment decision in the region. If there are more concrete developments towards an EU collapse such as a “Frexit” referendum, we would expect a rally to safe haven assets such as gold and bonds. There will likely be a ‘flight to quality’ in bond markets as investors seek shelter in perceived higher quality bond markets such as Germany and the United States with the European periphery yields blowing out, especially the likes of Spain, Portugal and Italy. The potential for an EU break-up would be negative for the Euro currency, as well as the Australian dollar because it is a risk correlated currency. Longer term, Le Pen’s protectionist policies and an EU break-up could trigger a global trade slowdown as a result of trade disputes and the break-up of free trade agreements which would be damaging to the global economy.

An EU collapse would be very negative for European equities in particular, and Australian listed companies with revenue exposure to the region such as Henderson Group Plc (HGG), QBE Insurance Group (QBE), CSL Limited (CSL), Lendlease Group (LLC), Sonic Healthcare Limited (SHL) and Ramsay Health Care Limited (RHC). We would however expect the contagion to spread to all corners of global equity markets. Companies with large material and energy exposures such as BHP Billiton Limited (BHP), Rio Tinto Limited (RIO), Woodside Petroleum Limited (WPL), Santos Limited (STO), Oil Search Limited (OSH) and South32 Limited (S32) could be impacted due to fears of slower global growth which typically has a negative impact on commodity prices. We also highlight Iluka Resources Limited (ILU) which derives over 25% of revenues from Europe as a risk. BHP Billiton Limited (BHP) and Rio Tinto Limited (RIO) do not specifically have a large exposure to Europe, but they are listed on the London stock exchange so these stocks could come under pressure on a relative basis. Generally, the health care sector should benefit from its defensive nature and a stronger USD would protect earnings especially for Resmed Inc (RMD) and CSL Limited (CSL). Cochlear Limited (COH) and Ramsay Health Care Limited (RHC) are at a greater risk because approximately 40% and 35% of their revenues are derived from Europe.

Small and mid-cap stocks would be more vulnerable due to their higher valuations and earnings risks, while the financial sector would likely experience the greatest impact to returns and drawdowns. European funds would see outflows as investors avoid the uncertainty within the European market. Australian banks would be subject to higher wholesale funding costs due to increasing European spreads and the large dependency of Australian banks on those markets. It is therefore possible that out of cycle bank rate hikes will increase in Australia even as the RBA maintains an easy monetary policy bias in 2017. This would support bank earnings but at the expense of the economy.

It would be difficult for Le Pen to remove France from the EU

A Le Pen victory will likely damage investor sentiment to a great extent, but it is not all doom and gloom because an EU exit would be difficult to achieve. Firstly, the French will go to the polls again in June to decide the lower house of parliament. Le Pen’s party, National Front, currently holds two seats in the 577 seat lower house so it is difficult to imagine her party being able to gain majority. If the house is divided, which we expect in the case of a Le Pen Presidential victory, she will be unable to form a coalition and will have a difficult time pushing through her agenda. This is important because the lower house has the power to approve or block a referendum. Secondly, the French constitution states that “the Republic shall participate in the European Union” so a constitutional change would be required in order to be able to leave the EU. This would be difficult. The change would need to be put to the lower and upper houses where there are very few right wing members in parliament currently. Thirdly, a referendum would need to be won in order to pull France out of the EU. We believe that this would also prove difficult because majority of the French still favour the EU, and it is rather the free flow of people and the fear of terrorism that the French are more concerned about. If a referendum were held, we do not believe the French would vote for a “Frexit”.

If we consider the risks on the horizon such as the French Presidential election, we believe that markets could experience bouts of volatility, causing equities to trade in a wide range. We believe that stock selectivity is very important in this environment and a dynamic approach could add value to client portfolios. We recommend stocks higher up on the quality spectrum, that are better capitalised and pay higher and consistent dividends, at least while the political risks exist. The consumer staples sector continues to offer defensive qualities and we like both Woolworths Limited (WOW) and Wesfarmers Limited (WES). Despite some of the following stocks having revenue exposure to Europe, we believe that the better quality resource stocks include BHP Billiton Limited (BHP) and Rio Tinto Limited (RIO), industrial stocks include Transurban Group (TCL) and health care stocks include Ramsay Health Care Limited (RHC), Sonic Healthcare Limited (SHL), CSL Limited (CSL) and Resmed Inc (RMD).

If we look back to the unexpected outcomes of the UK referendum and the U.S. Presidential election, investors should not underestimate the possibility of a Le Pen victory. Markets have however done a good job of looking through the outcomes and the associated political risk and Brexit is a good example of how quickly markets can bounce back. The focus has instead been on the fundamental economic environment which is clearly improving around the world as well as in Europe. We are of the view that volatility and global market events will always be present and that over the long term, whilst keeping valuations in mind, investors will be rewarded by positioning toward high quality companies that present reasonable growth, solid financials and good management. For medium to long term investors it is therefore important to look through the bouts of volatility associated with political events, have a balanced portfolio utilising funds which have the ability to dampen the downside risk and to remain realistic in this high risk, lower return environment.Source: IOOF

Disclaimer: The information in this report is general advice only and does not take into account the financial circumstances, needs and objectives of any particular investor. Before acting on the advice contained in this document, you should assess your own circumstances or seek advice from a financial adviser. Where applicable, you should obtain and consider a copy of the Product Disclosure Statement, prospectus or other disclosure material relevant to the financial product before making a decision to acquire a financial product. It is important to note that investments may go up and down and past performance is not an indicator of future performance.

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