French election takeaway: don't write off populism yet

It looks like opinion polls got the first round of the April 23 French presidential election broadly correct: Centrist pro-European candidate Emmanuel Macron and far-right populist Marine Le Pen are set to advance to the runoff vote on May 7. If the latest polls are anything to go by, Mr. Macron is likely to win the second round with over 60% of the vote.¹

In our view, a Macron victory is probably the best outcome for the French economy and for an integrated Europe. However, just because Ms. Le Pen is unlikely to win the overall election, don't assume that she has lost—this fight between centrists and populists is far from over.

Not since Charles de Gaulle's rise to the presidency in the 1950s has an independent French presidential candidate come so close to winning. While Mr. Macron has never held elected office, he has impressively led his party, En Marche!, to the second round presidential vote just a year after he founded the party in April 2016. He generally stands for the liberal economic order that seems to be under threat across the Western world: He's pro-European, aims to keep France open to trade and immigrants, and believes France should shrink its bloated public sector. In his campaign, he promised to cut 120,000 public sector jobs and reduce public spending. He also hopes to modify France's government-mandated 35-hour work week so companies can negotiate regular working hours and overtime with labor unions. Another proposal would merge France's 35 public pension funds into a single fund.²

Mr. Macron's economic policies are seemingly less shock and awe than those of the other candidates, and are therefore more likely to be passed through the French Parliament without inciting widespread social unrest. While it appears likely that he'll win the presidency, we believe it will be difficult for his party to gain a majority in the National Assembly, France's lower house, in an election scheduled in June. Without a majority, Mr. Macron may need to seek a coalition to govern. This isn't impossible: Center-right presidential candidate Francois Fillon, socialist candidate Benoit Hamon, and socialist former Prime Minister Manuel Valls have already backed Mr. Macron over Ms. Le Pen. In addition, while cross-party coalitions have historically been an alien concept in French politics at the national level, there is some history of such coalitions governing at the local level. Mr. Macron has proven he can buck precedents; unless he can maintain this record, he's likely to find it difficult to secure approval for his policies.

Given the strong likelihood that Mr. Macron will defeat Ms. Le Pen in the runoff election, some analysts have declared that European populism has already passed its prime. Most investors would welcome such a development, as it would suggest that the liberal global economic order will remain intact and that any market volatility linked to speculation regarding the demise of the common currency or the European Union would dissipate. However, I believe this view is mistaken.

First, it's worth mentioning that Ms. Le Pen's loss in the runoff election isn't a certainty; it's notoriously difficult to accurately predict voter behavior in such elections. In the first round, about 40% of the French electorate voted for candidates that some would consider to be extremists.³ Over 22% of eligible voters didn't cast ballots, and their votes could affect the outcome in the runoff election. However, the gap between Mr. Macron and Ms. Le Pen in the runoff is expected to exceed 20 percentage points, based on opinion poll results. A victory by Ms. Le Pen would be surprising and would trigger enormous market volatility, in our view. Such an outcome is far from our base case, but the risks associated with this would be substantial.

Given the circumstances, it's likely that Ms. Le Pen will lead France's political opposition—if not in terms of the number of seats her party holds in the National Assembly, then in terms of sympathizers with her antiestablishment views. This is the best possible position for any populist party to find itself in, in my view. Populists often struggle in government, shackled by the responsibilities of legislating and implementing. Typically, populists' support and influence remain higher when they're protesting from the sidelines in opposition. Ms. Le Pen's Front National has already had some success in this regard, as the party has influenced national political discourse on issues such as France accepting Syrian refugees and the compatibility of Islam with the values of the French Republic. In the sweep of investor optimism surrounding the results of the first ballot, we believe investors need to be wary of Ms. Le Pen's potential influence on economic policies, as these policies tend toward isolationism, the bane of strong growth.

Looking beyond France, the populist threat is arguably alive and well in the United States and the United Kingdom. As for the eurozone countries, the threat is most worrisome in Italy, where elections are expected to be held by March 2018. The populist, anti-euro Five Star Movement (M5S) consistently places first in public opinion polls in Italy,⁴ a country that's less enthusiastic about the euro than France.⁵ If it were to lead the next government, the M5S would have trouble building a coalition, and it's likely that the party would seek a national referendum asking voters whether to abandon Italy's use of the euro. Under such a scenario, investors would again face a potential threat to European integration that could cause severe economic and financial disruptions.

Such political outcomes are binary events that can severely challenge the economic order and investor attitudes toward Europe. This uncertainty is regrettable, as European equity markets generally trade at a meaningful discount to U.S. equities on a valuation basis, and Europe's economy has recently extended its sustained recovery, albeit at a tepid pace.

A victory by Mr. Macron in the runoff election would likely be regarded as a risk-on event for the markets, making investors less risk averse in aggregate. But I wouldn't break out the champagne just yet. Depending on the outcome of the National Assembly elections in June, Mr. Macron may have trouble pushing through his pro-European, pro-business agenda. In addition, although Ms. Le Pen is unlikely to be in the new government, she'll have even more impact in opposition. In our view, the probability of a breakup of the eurozone sparked by the French election was always very low, and we think that such an outcome is now almost certainly off the table. But that doesn't mean that anti-European parties will not threaten the currency union in other countries or in future elections.

1 “France's Macron appears set for Elysee in runoff with Le Pen,” Reuters, 4/23/17.

2 “A consequential choice for France-and an uncertain one,” Economist.com, 3/3/17.

3 “Early evening French election turnout down from 2012,” Reuters, 4/23/17.

4 “Italy's Five Star takes aim at free-trade deals,” Financial Times, 4/6/17.

5 "Out of pocket, Italians fall out of love with the euro," Reuters, 2/8/17.