President Le Pen: picturing the tail risk

Ever so quietly, amid the noise of the UK delivering its Article 50 letter to the European Council and the boisterousness of French and German electoral politics, Europe’s economy has been staging a remarkable recovery.

Investors appear to be penalising Europe based on a perception that its politics are a mess and its economy is mired in a fundamental economic malaise with little hope for improvement. We think it is time to rethink that perception – not least because the data is already refuting it. “European value” in the economy could end up being a bigger investment story than the threat to “European values” in its populist politics.

But we also acknowledge that it is sensible to assess the possibility of a major populist breakthrough. Polls for the French Presidential election have been tightening, raising the very real prospect of Marine Le Pen of the National Front (FN) facing off against Jean-Luc Mélenchon on the far-left in the second round. In this note I sketch out Europe’s incipient economic recovery and then discuss perhaps the biggest threat to that recovery: the possibility that Pen ascends to the Presidency of France and successfully implements her campaign promises.

Europe’s improving fundamentals
The economic headlines are shown in Figure 1. Real growth in the Eurozone is now at a year-onyear rate close to 2%. In addition, business climate indices show increasing confidence, running well above average levels. Economic data has been beating estimates for a year, now. Purchasing managers’ indices show sentiment at its most optimistic in six years, while credit is expanding and unemployment is falling even in the long-suffering periphery of the Eurozone. All of this might have stoked rising consumer prices, but so far core inflation has remained subdued, enabling the European Central Bank (ECB) to maintain its accommodative stance on monetary policy.

It’s easy to understand why this gets drowned out by Europe’s politics at the moment. They were fragile even before the “Brexit” vote last June. Investors who saw Donald Trump get into the White House have been concerned that populists might enjoy big gains in general elections in the Netherlands and Germany, and that Marine le Pen of the National Front (FN) might even be elected President of France.

Nerves have been eased a little by the poorer-than-expected showing for the Freedom Party (PVV) in the Netherlands in March, and the way the rise of Martin Schulz of the Social Democrats (SPD) is making Germany’s election in September look more like an old-fashioned race between two mainstream parties.

But here we will focus on France. The presidential election is both the most imminent and arguably the most serious threat to European mainstream politics. The consensus is that a victory for Le Pen could pose an existential threat to the Eurozone and even the EU itself. The rise of the far-left candidate Jean-Luc Mélenchon in the latest opinion polls only adds to investors’ concerns.

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