The first round of the French election was bang in line with the polls. The equity market reaction on Monday was clearly positive, with the European markets rising 3%, and the rest of the world around 1.5%. The driving force behind this may not have been elation at Emmanuel Macron’s victory as much as a sigh of relief at the defeat of Socialist candidate Jean-Luc Mélenchon. A second round of Mélenchon versus Le Pen would have created a very close race, with both outcomes potentially negative – socialism versus nationalism doesn’t create a lot of market winners. Macron, on the other hand, is pro-business, and if the polling accuracy continues in the second round, he should beat Marine Le Pen by a decent margin (currently pegged around 20%). However, the race is by no means completely over.
There is no question that Le Pen believes that this is a winnable battle, and she will spend the next two weeks trying to claw back some of that polling difference. Rather than steal votes from Macron, it is likely that we will see the Le Pen campaign focus on getting ‘swing’ voters to abstain or spoil their ballot papers, and by painting Macron as a classic establishment figure in a poor disguise. If the Le Pen campaign is run along the same lines as the Leave. EU or Trump efforts, social media usage could amplify this effect.
Macron, too, has to keep working hard. A high turnout is his best chance of sweeping the board, but the higher his polling margin, the more complacent those swing voters may be. Acting like a President-in-waiting (as some suggested he did on Sunday) may reinforce that message, as well as come across poorly to the truly undecided voters.
All that being said, a 20 point lead is tough to argue against. Assuming no scandals or revelations (perhaps a big assumption), Macron should win. How effective he can be as President is still up in the air. We will have to wait until June for the parliamentary elections to see how strong his hand is – given that his entire party didn’t exist until a year ago, no one is expecting a majority for En Marche. That being said, a politically impotent Macron is still likely to be more favourable for markets than Le Pen.
Our approach to European Equity has differed across the portfolios in the past month. In our March Tactical Asset Allocation analysis European Equities looked attractive, as did the Euro. However, for the Balanced risk profile and below, we decided to reduce exposure to the tail risk of a shock first round result, and cut European equity exposure in order to avoid any potential volatility. In the Moderately Adventurous and Adventurous profiles, we maintained our overweight to European Equity, accepting the chance of increased volatility in order to capture the upside. Furthermore, in Adventurous, we also added Euros (which have also rallied).
Now, with the hurdle of the first round cleared, and the odds looking better for a market positive result, we are looking to increase European Equity in all of the portfolios. Last week, we took profits on half of our US Inflation Swap position, and we are using the cash raised (in varying degrees) to fund the European Equity allocation.
With the hurdle of the first round cleared, and the odds looking better for a market positive result, we are looking to increase European Equity in all of the portfolios.
It was almost a year ago that we bought the US Inflation Swaps and this position gained 5%. Over the same period, US Inflation Linked bonds (which we sold to buy this pure inflation protection) have been flat, dragged down by the fall in the value of the pure fixed income part of the instrument (see the grey line on the chart below).
We continue to hold a 3% position in Inflation Swaps in all of our risk profiles apart from the Adventurous risk profile. We still like the value offered compared to Inflation Linked bonds, which are as unattractive now as they were last April (offering a real yield of just 0.5%).
We also like the portfolio flexibility to add or remove conventional bond duration without affecting our inflation protection – as we have done on several occasions over the past 12 months.
Inflation Certificate performance
But while the Inflation Swap has equity-like characteristics, we believe Europe offers more upside for the time being. There are still some French political obstacles in the way – the second round, the parliamentary elections – but, as each of these is overcome, it improves the chances that a European rally could continue for some time.
An overview of the changes is below:
- In the Cautious and Moderately Cautious funds, some of the cash will be put in Europe and some cash still kept in reserve. This should be roughly risk neutral.
- In Balanced, we make a straight swap of inflation for European Equity. This represents a small increase in risk.
- In Moderately Adventurous and Adventurous, we add a larger amount of European Equity, partly funded by inflation and partly by selling down US Equity to a large underweight.
At the same time, we have taken the opportunity to switch some of our US Dollars into Euros, taking our Euro exposure up to neutral. This diversifies our foreign currency exposure, while still keeping a high level of Sterling.
[Click table to view full size]