Markets are still underpricing Frexit risk, analysts warn

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French asset prices have calmed ahead of the country’s first round presidential vote in three days’ time but beware the lull, say analysts who fear investors are still too complacent about the risks of eurozone’s second largest country breaking out of monetary union.

France’s 10-year bond spread with German Bunds – a closely-watched measure of election risk – has narrowed today to around 73 basis points (0.73 percentage points) having spiked close to 78bps last week.

Despite the relatively sanguine signals from the bond market, the race has been blown open by a surprising surge in the polls for far-left candidate Jean-Luc Mélenchon this month.

A veteran of the French left, Mr Mélenchon’s arrival in the race – in third spot behind rivals Marine Le Pen and Emmanuel Macron – has added another anti-EU, anti-establishment candidate to the mix.

“Markets are unprepared for the worst,” notes Athanasios Vamvakidis at Bank of America Merrill Lynch. “The worst outcome for markets is if Le Pen and Mélenchon are in the second round, in our view, as markets could start pricing Frexit risks”.

Although not going as far as Ms Le Pen’s call for a euro referendum within six months, Mr Mélenchon has vowed to rip up the EU’s treaties and embark on a near €300bn spending spree that would break France’s budgetary commitments under the Lisbon Treaty. He also wants to revoke the European Central Bank’s independence, lower France’s retirement age and impose a nationwide salary cap.

By contrast, Mr Macron and Republican candidate François Fillon are promising to tame France’s public finances and reform the EU from within.

“The market is missing the bigger picture. There are grave, grave problems for Europe in the next few years”, warns Derek Halpenny at MUFG.

“If Le Pen is sitting at the heart of Europe, or indeed the National Front gains more influence in the Parliamentary elections in June, attempts to fix these problems are going to be blocked at every turn.”

All four candidates are polling within the 19-24 per cent range according to the FT’s poll of polls (see above).

“The choice is unusually stark between two pro-EU supply siders and two EU/eurosceptic big spenders”, says Gilles Moec, economist at BAML.

“There are six possible combinations on who could make it to the second round, all almost equally likely according to the polls. This should be enough to keep the market on its toes,” says Mr Moec.

BAML’s latest survey of fund managers shows equity investors have moved from US to eurozone equities at their fastest pace since the start of monetary union in 1999 as investors think the euro is undervalued in the run up to the vote.

But the single currency is in line to suffer a depreciation of Brexit-like proportions should Ms Le Pen triumph in the second round and undergo a “sharp” downward lurch if Mr Mélenchon makes it to the Elysée Palace, says BAML.

Jane Foley at Rabobank also thinks the euro is “exposed to a negative shock” in the run-up to the vote.

Despite the number of negative bets on the euro rising in recent weeks, “they stand well below the levels at the end of last year”, adds Ms Foley.

“If Mr Macron is beaten by both Le Pen and Mélenchon, we would expect the euro to tumble”.

The four-horse race is “unprecedented” in the history of the French fifth republic, says Mujtaba Rahman, analyst at Eurasia group, who thinks the Frexit-supporting Front National candidate has a 40 per cent chance of prevailing in the final vote.

Although most polling shows opposition forces from across the political spectrum will mobilise against Ms Le Pen, Mr Rahman thinks a clear first round lead will be key to her fortunes.

“If Le Pen arrives first on Sunday with a clear lead over the runner-up, this could also normalize her candidacy for some hesitant voters, eroding any counter-mobilization”, he adds.

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