The twists and turns in the race for the French presidency are acting as a red flag for Asia-based investment managers, who advocate avoiding continental European equity and debt while political risks remain elevated and asset valuations are not cheap.
First-round voting for the French presidency will take place this coming Sunday, and if no single candidate wins a majority, there will be a second round in early May for the two highest-scoring candidates.
If the eurosceptic far-right and far-left candidates, Marine le Pen and Jean-Luc Mélenchon, end up in the run-off together, the very foundations of the European Union could be under threat, potentially sending markets into a tailspin.
Jean-Louis Nakamura, Lombard Odier’s France-born chief investment officer for Asia Pacific, said he had never witnessed an election like it.
“It’s completely unprecedented to see just 4% between the four main candidates at this stage,” he commented. “It really could go in any direction, and as Brexit and the US presidential elections demonstrated, we should expect the unexpected.”
Both Britain’s June vote to exit the EU and the success of Donald Trump in November took most investors by surprise.
Crisis after crisis
And even if one of the two pro-EU candidates – François Fillon or Emmanuel Macron – were to win, Asian fund managers said they would remain wary of Europe. The French presidential election, they argued, appears to be just the latest manifestation of an existential crisis shaking the EU.
Lim Say-Boon, CIO at Singapore’s DBS Bank, noted that Europe has been plagued by one prospective sovereign debt crisis after another over the past seven or eight years.
“None of these risks have eventuated yet, but they remain very real,” he told AsianInvestor. “We can’t go overweight European equities in the hope Greece somehow doesn’t default. We have a fiduciary duty to manage our clients assets responsibly.”
Yet Lim added that the European Central Bank had been able to counter these risks successfully through its enormous quantitative easing programme (QE). By the end of 2017, it will have made €2.28 trillion ($2.46 trillion) in asset purchases, equal to 25% of the euro-area economy.
This has created ample liquidity and pushed equity and bond markets higher. This is the main reason why the Brexit fallout was manageable and short-term, said Lim. As a result, DBS currently has a neutral stance.
Lim argued that the one strong buying opportunity for European risk assets came in July 2012, when ECB president Mario Draghi uttered the three magic words “whatever it takes” to describe the bank’s intention to save the euro.
A “positive” outcome to the French presidential election would not offer much of a buying opportunity, Lim added, since the ECB looks set to exit its QE programme at the end of the year.
Lower Europe allocation
Lombard Odier’s Nakamura has 3% to 4% of his global portfolio in European equities, half the allocation of a few months ago. His biggest holding is in long-dated bonds (21%), followed by dollar-denominated emerging Asia credit (19%) and emerging-market equities (17%).
Nakamura said it was very difficult to hedge the political risks associated with the French presidential election, given that the potential outcomes are so binary.
But the main reason for the low weighting, he noted, is that European stock prices do not stack up on a risk-adjusted basis. “Emerging-market equity and debt still offer much better carry, even though they’ve been getting more expensive recently,” argued Nakamura.
Investors seem to agree. Emerging markets attracted a net $28.6 billion of capital in the first quarter of 2017, a sharp improvement on the $238 billion that was pulled out in the last three months of 2016, according to NN Investment Partners. Indeed, EM flows have turned positive for the first time since the second quarter of 2014, said NNIP.
DBS’s Lim took a similar view. “European equities are just not cheap enough compared to emerging markets to justify recommending that clients go overweight if some of these near-term political risks die down,” he noted. “Asia looks so much more promising as it’s coming out of a multi-year earnings recession.”
Lim also believes that recent positive economic news has been priced into European stocks, which average a forward price-to-earnings ratio in the mid to high teens. The most recent Eurozone Purchasing Managers Index recorded its fastest rise in six years for the first three months of 2017.
This has helped France’s CAC 40 and Germany’s Dax indices post positive performance so far this year, with respective returns of 4.43% and 4.76% as of yesterday's close. Still, they have underperformed Asian benchmarks such as Hong Kong’s Hang Seng, which is up 10.52% over the same period.
Meanwhile, French government bonds have underperformed their German counterparts, suggesting a potential short-term buying opportunity, should a centrist win the election. Since the start of the year, the spread between 10-year French and German sovereign debt has widened from 47bp to 65bp as of Friday’s close.
Of course, once the French vote is settled, attention is likely to turn towards the next potential flashpoint: Germany’s parliamentary elections in September.
“What happens if Angela Merkel is no longer chancellor or even damaged as a leader?” Lim said. “It’s been her statesmanship which has kept German popular opinion behind Greek support. That sovereign debt crisis has not gone away at all.”