Ahead of the first round of the French elections on Sunday, Deutsche Bank's equity strategist Sebastian Raedler again reminds his bank's clients and the seemingly unperturbed markets, that despite the tightening of the poll numbers among the four front-runners, European equities show little sign of pricing in a meaningful political risk premium. In fact, as he notes below, European equities appear to not have priced in even a modest political risk discount.
This may be a mistake. As a reminder, if we look at the last 3 polls run by those pollsters then the spread between the four candidates is at an average of 4.5%. Macron’s average is 23.3%, Le Pen 22.3%, Fillon 19.7% and Melenchon 18.8%. So it’s quite possible that these 4 candidates will be clustered together given that the spread is within the margin of error from previous elections (see "Is A Le Pen - Melenchon Second Round Possible: A Concerned Deutsche Bank Answers").
Meanwhile, as equities fell 8% ahead the UK referendum last June and 4% ahead of the US elections in November, they have remained close to their recent highs this time around – and now trade around 3% above the fair-value levels suggested by DB models. European banks have also held up well despite falling bond yields, with their price relative around 5% above the level implied by the German 10-year yield.
Raedler further notes that Deutsche Bank expects only moderate upside for European equities in case of a Macron/Fillon victory in the second round on May 7th (~3%), moderate downside in case of a Mélenchon win (~3%) and significant downside in case of a Le Pen victory (~15%).
So what to expect on Sunday?
According to DB, polls ahead of the first round of the French presidential election on Sunday show the four front runners within five percentage points of one another, with Macron at 24%, Le Pen at 22% and Fillon and Mélenchon at 19% each.
Our rates strategists highlight that the average polling error for the first round of past French elections has been six percentage points, suggesting that the scope for a surprise relative to the consensus expectation of a Macron / Le Pen run-off remains high. Polls suggest that Macron would beat Fillon, Le Pen and Mélenchon in the second round, while Mélenchon would beat Fillon and Le Pen, and Fillon would beat Le Pen – all by a margin comfortably above the historical maximum second-round polling error of 10 percentage points.
That much is known, but what is priced in? It appears that when it comes to stocks at least, the answer is nothing but blue skies.
As Raedler puts it, European equities are not priced for a political risk discount: despite the closeness of the first-round polls, "there is no obvious political risk discount priced into the European equity market."
At 14.9x, it is trading around 2% above the current fair-value implied by our P/E model (14.6x) and around 3% above the level implied by our short-term Stoxx 600 fair-value model (378 versus 365). This suggests European equities are still priced for a slight valuation premium on the back of the recent sharp acceleration in global growth momentum, rather than a political risk discount.
While increased political risk led European equities to correct by 8% ahead of the UK referendum in June last year and by 4% ahead of the US presidential election in November, we have not seen a similar pull-back this time around, with the market trading close to its 2017 peak. We expect moderate upside for European equities in case of a Macron or Fillon win in the second round of voting on May 7th (~3%), moderate downside in case of a Mélenchon win (~-3%) and significant downside in case of a Le Pen win (~-15%). This implies mild upside for European equities if the first-round vote results in a Macron / Fillon run-off, more meaningful downside in case of a Le Pen / Mélenchon run-off and less clear directionality for all other scenarios.
How about European banks. Here equities are likewise holding up well despite the recent fall in bond yields:
European banks’ relative prices have moved closely in line with German 10-year bond yields over the past two years – but are now around 5% above the level suggested by bond yields after their recent fall to 0.2%. Our fixed-income strategists expect German 10-year bond yields to rise to around 0.5% in case of a Macron or Fillon win, to fall to 0.1% in case of a Mélenchon win and to fall to -0.1% in case of a Le Pen win.
For DB, this would imply 5% outperformance for banks in the Macron / Fillon scenario, 8% underperformance in the Mélenchon scenario and 14% underperformance in the Le Pen scenario .
Finally what about French domestic cyclicals? Here DB expects a play on reduced political risk.
French stocks with high domestic sales exposure and a negative correlation with peripheral bond spreads (most of them financials) have underperformed defensive French exporters by around 10% since the beginning of the year, a worse performance than would have been suggested by the historical relationship with bond yields. If the political risk scenario in France is avoided, we would expect this trade to re-connect with bond yields (pointing to 10% relative upside). Similarly, French financials have underperformed German financials by more than implied by the relationship with bond yields, a trade that is also likely to reverse in a benign election scenario
All of the above in charts: