After starting the year fretting about France’s presidential contest, investors are toasting the prospect of Emmanuel Macron defeating Marine Le Pen next month, spurring significant gains for the euro, European stocks and bond prices.
That is not to assume European political risk is at bay. While investors are convinced that the centrist Mr Macron will comfortably defeat his far-right opponent in the second round on May 7, he lacks the backing of a major party, meaning he must negotiate with France’s National Assembly to gain support for his policies.
Mr Macron is widely regarded as market-friendly, having set out during his campaign some ambitious plans for fiscal consolidation, labour market reforms, and increased European political and economic integration.
He aims to implement swift spending cuts to reduce the French deficit, but could swiftly run up against the bruised egos of France’s major parties, for whom the first-round election result was an unprecedented humiliation.
So the outcome of Assembly elections in June “carry more weight than usual, possibly even more than the presidential election”, according to Barclays economist Francois Cabau.
Policy implementation therefore becomes the market’s next political risk factor, just as it has in the US, where Donald Trump faces Congressional gridlock, and in the UK, where Theresa May has called a snap election to shore up her parliamentary majority.
France has been here before. Economists are mindful of a painful repeat of cohabitation, when a president and prime minister come from different political parties, a feature of French politics in the 1980s and 1990s.
“Excessive fragmentation would not be positive and would give rise to a Dutch disease — no agreement in supporting a new government for several months,” says Lorenzo Codogno, chief economist at LC Macro Advisers.
The “baseline scenario” of a “sort of grand coalition” would be “a big novelty for France, with all the uncertainty that this would produce”.
Although French-German government bond spreads have narrowed as a result of the first-round vote, uncertainty about the parliamentary make-up in France “will probably continue to weigh” on the spread in the next six weeks, says Morgane Delledonne, a fixed-income strategist at ETF Securities.
This means the European Central Bank, which meets later this week, is very unlikely to flag any policy changes in the near term.
Ray Attrill, head of FX strategy at National Australia Bank, says the first-round vote will not provide a green light for ECB tapering.
“The earliest that conceivably changes is June,” he says when the ECB will be armed with updated forecasts and the certainty of the French election outcome.
For now, investors are embracing French and eurozone risk assets, a trend that began emerging ahead of Sunday’s vote, buoyed by polls showing Mr Macron was likely to affirm his frontrunner status. Ahead of the second-round vote, optimism over the wider eurozone landscape is also being underpinned by signs of an improving global economy.
“Le Pen will almost certainly be defeated in two weeks’ time, and equities can continue to rally going into 2018 as non-existential risks can be absorbed,” says Bill Street, head of investments for Europe, the Middle East and Africa at State Street Global Advisors.
Reassured that the French polls were correct in predicting the first-round outcome, they will keep faith with the pollsters who cannot see the National Front and anti-euro candidate get more than 40 per cent of the vote in the run-off.
Reflecting a sense of relief, the euro at one point rose 2 per cent to a five-month high of $1.0935 versus the dollar, while also gaining ground against the yen and the pound as measures of implied currency volatility eased sharply.
“Vive l’euro,” declares Ulrich Leuchtmann, Commerzbank FX strategist, “ . . . everything seems to have fallen into place for the euro on the FX market.”
Goldman Sachs says the chances of Ms Le Pen becoming president or of the eurozone breaking up are close to zero, and foresees the euro pushing up to $1.13 against the dollar.
In bond trading, French bond yields registered an appreciable decline against those of German Bunds, a tend that has room to run.
The result “should lead to a material reduction in perceived political risk in Europe”, says Jean Boivin, head of economic and markets research at BlackRock Investment Institute, which would “allow investors to focus on the region’s improving growth”.
As a result BlackRock is “underweight European fixed income” because of “risks that the improving economic outlook will spur higher bond yields and wider spreads on investment-grade corporate bonds”.
While there are plenty of doubts to keep investors on their toes, not least about the strength of the global reflation story, the market mood is nonetheless upbeat.
Mr Leuchtmann reflects that bullish tone. “It seems to be high time that the forex market finally prices in the expected ECB tapering to a notable extent,” he says. “Euro strength caused by that outlook is justified and sustainable in my view.”