French Elections and Les Autres Stuff

Summary:  April has turned out to be an active month on the geopolitical front and in markets.  The last week of the month is not going to be an exception as France, the United States, Italy, North Korea and Venezuela are all likely to remain in the headlines.  The net impact is that while the news out of France was good for markets and the global economy, there are significant risks with other developments which dampen investor expectations. The U.S., in particular, is likely to see considerable negative political press as the Trump administration seeks to advance a continuing budget resolution through the Congress, but positive economic data probably will continue to demonstrate economic expansion, evidenced by strong earnings.  The VIX ended last week at 14.63 and the 10-year Treasury was 2.237%; look to the VIX to go lower initially, but climb again through the week and for the 10-year Treasury yield to remain roughly where it is as risk mounts in the U.S. and North Korea.

France – Round Two!: The first round of the French presidential elections has already produced plenty of corny titles for articles, with one of the worst being, “Le Pen is Not Mightier than the Macron”. No doubt that as France heads toward the May 7th second round vote between far-right candidate Marine Le Pen and centrist Emmanuel Macron, more bad titles will follow. However, the outcome, which is currently projected with Marcon at 23.7% of the vote and Le Pen at 21.7%, is positive for markets.  French opinion polls proved relatively accurate and currently indicate that Macron should handily defeat Le Pen in the next round, roughly 60% to 40%.  We think it could be a little closer, but Marcon should winThe euro has already rallied on the news.

Projected Results April 23, 2017
Macron  (Le Mache!)          23.9%
Le Pen  (National Front)    21.4%
Fillon  (Republicans)          19.9%
Melenchon  (LFI)                19.6%
Hamon (Socialists)               6.3%
Dupont-Aignan (DLF)         4.7%
Others                                     4.2%
Total                                   100.0%

A few points are worth noting for what comes next. Round one was a victory for the “outsiders”. Although the cases can be made that both Le Pen and Macron have been part of the “system” for a long time, what is striking is that Le Pen’s National Front and Macron’s En Marche! (established only late last year) have never been in power.  The two major blocs, represented by the center-right (through various parties, the latest being the Republicans) and Socialists have dominated Fifth Republic politics since 1958.  This is the first presidential contest in which one of the major parties did not place a candidate, reflecting a deep disenchantment with the traditional parties and a willingness to embrace outsiders. Benoit Hamon, the Socialist candidate, is projected to win only 6.5%.

The new political alignment that will be played out in the remaining two weeks of the election will stress Le Pen’s emphasis on the nation-state, strong defense of the borders (from both terrorists and immigrants), protectionism in trade, a return to the franc, a referendum on leaving the European Union, closer relations with Russia, and an extension of the state into the economy and society (more benefits and a roll-back of labor reforms undertaken by the outgoing Hollande government).  Le Pen will also seek to paint Macron as part of the establishment, especially after he has received the endorsements of Fillon and Hamon.

This will be in contrast to Macron’s call to make the European Union work better, overhaul state finances, reduce the social welfare state, maintain the autonomy of the central bank, support NATO and push more labor market deregulation. Indeed, Macron’s plans call for the reduction of 120,000 public sector jobs and 60 billion euros in spending.

One last item on the French front is that the worst-case scenario was averted — a second round between Le Pen and far left Jean-Luc Melenchon, who finished fourth and had enjoyed a late surge in the polls.  French voters now have to endure two more weeks of electioneering as the two candidates left standing battle for their attention.  We remain true to our first call — Macron will be the next president of France. The first round result is good for markets and the euro.

Les autres stuff…
While the French elections dogged markets last week, they are likely to recede as a risk factor. Indeed, we would venture that next week the drama will return to the U.S., where the Trump administration is pushing Congress to avoid a government shutdown on April 28, while pushing the legislative body to move quickly on another attempt to pass a repeal bill of the Affordable Care Act (ACA).  President Trump also indicated that he plans to unveil his plan to overhaul the tax code.

The funding bill is probably the most significant story, as in addition to asking for funding to keep the federal government running, the Trump administration is asking for $3 billion for border security and the construction of a border wall and an additional $30 billion for defense spending. These items incur Democratic opposition and generate mixed feelings within the Republican camp.

There is considerable pressure on President Trump to have something to show on the legislative front for his first 100 days. The last effort to repeal and replace the ACA failed. However, presidencies are not determined by the first 100 days, but through their duration.  The outcome will probably be another extension on funding the government as Congress, especially the Republicans, do not want to be blamed for shutting the government down.  We would also expect that between tax reform and a new effort on healthcare, the Trump administration will pull something through the Congressional mire over the next several months. Funds for the construction of the border wall may have to wait.

Investors should also be aware that North Korea has not left the stage. North Korea usually follows significant dates with an ongoing stream of military power demonstrations. On Tuesday, North Korea celebrates the founding anniversary of its military. South Korean officials are warning that Kim Jung-un could opt to conduct a new nuclear test or launch its maiden test of an ICBM.  Indeed, U.S. commercial satellite images indicate increased military activity around North Korea’s nuclear test site, while Kim has indicated that the country’s preparation for an ICBM launch is in its “final stage”.

North Korea’s actions are closely tied to one thing — regime survival. While the rest of the world regards North Korea’s actions as highly provocative and the Trump administration has noted that strategic patience is over, much of the Kim regime’s actions are to probe how far it can go and hope to extract something from its actions. At the same time, the North is well aware that any efforts, like the U.S. strike in Syria, would lead it to threaten to turn “Seoul into a sea of flames” or strike out at Japan.  This makes striking North Korea a very risky venture.

We suspect that China has leveled considerable pressure on North Korea.  There have been reports that gasoline, which is imported from China, is in short supply in the North. China does not want the U.S. to strike at North Korea — an action that could unleash war on its border and radically change the geopolitical structure of international relations in Northeast Asia. Look for more North Korean drama, but the Kim regime’s actions may a little more limited. Ultimately, we suspect that North Korea will see regime change, much along the lines of what happened in Romania in 1989, but with considerable Chinese help. For those who do not remember, the near-totalitarian regime of Nicolae Ceaușescu ended when the aging despot and his power-hungry wife, Elena, were ousted from power and then lined up in front of a firing squad on Christmas Day.

And what about Italy?: Now that fears over a Le Pen victory are receding, Italy takes its place as our biggest risk factor in Europe. The economy is likely to struggle to get to 1.0% real GDP this year, while unemployment stood at 11.5% in February.  The ruling Democratic Party-led coalition remains in control of the government for now, but it has fractured with a number of more leftist members setting up their own anti-austerity party.  At the same time, the populist and anti-EU Five Star Movement has led in opinion polls, which could pose big problems for the rest of Europe should that party and other anti-EU parties gain an outright majority in parliament.

Italy Economic Data

2014 2015 2016 2017 2018
Real GDP % 0.5 0.8 0.9 0.9 1.0
Inflation % 0.2 0.1 -0.1 0.8 1.0
Unemployment rate % 12.6 11.9 11.5 11.0 10.7
Gen. govt. fin. Bal/GDP % -3.0 -2.6 -2.4 -2.4 -2.4
Gen. Govt. debt/GDP %

(Maastricht definition)

131.8 132.4 132.1 132.2 132.0

Source: http://www.oecd.org/eco/outlook/economic-forecast-summary-italy-oecd-economic-outlook-november-2016.pdf.

The Five Star Movement favors ditching the euro and returning to the lira, as well as cutting taxes and raising social benefits.  Considering the weak condition of Italian banks, the political overhang is not good news for their business or the general economy.

On April 21 Fitch cut Italy’s sovereign ratings from BBB+ to BBB, with a stable outlook. The rating agency said the downgrade was due to huge debts (equal to 132.6% of GDP), a stagnant economy and divided politics.  At the same time, Fitch’s outlook for Italy’s banking sector was negative, reflecting the high level of non-performing loans and weak profitability. Three banks – Monte dei Paschi di Siena (one of the largest in the country), Banca Popolare di Vicenza and Veneto Banca – are seeking public intervention to keep them afloat. The Italian banking sector as a whole is weighed down by some 203 billion euros ($US 217.68 billion) of bad loans. Fitch said that ahead of next year’s election, the “risks of weak or unstable government have increased, as has the possibility of populist and eurosceptic parties influencing policy.”

Fitch is not alone in having concern over Italy’s creditworthiness. Canadian rating agency DBRS cut Italy’s sovereign rating in January 2017 due to the same problems highlighted by Fitch. Moody’s Investors Service also has the country on a negative outlook, meaning a downgrade looms. No election is officially scheduled, but Italy is in its third government since the last election and speculation is growing that the country could go to the polls before 2018.

Last, but hardly least is Venezuela.  The country’s economy is in free-fall as are its politics. While basic staples for daily life are difficult to obtain, law and order appears to be breaking down. It could well be that the Maduro regime’s socialist experiment is reaching into its end-game — if it cannot control the streets with a combination of police, thugs and the military, the country is heading into civil war.  This means that the state-owned oil company, PDVSA, long expected to default on its debt, could finally do so.

Venezuela Economic Data

Economic Snapshot 2016 2017 2018
Real GDP % -18.0 -7.4 -4.1
Consumer Prices 254.9 720.5 2,068.5
Current Account bal./GDP % -2.4 -3.3 -2.1
Unemployment % 21.2 25.3 28.2

Source: International Monetary Fund

We are also concerned about the impact of a failed state in Venezuela on the neighborhood, including Colombia, Guyana, Suriname, the Dutch islands of Aruba, Bonaire and Curacao, and Trinidad and Tobago.  A failed state could see a surge in Venezuelans fleeing conflict, greater illicit flows of money and arms throughout the Caribbean and an upsurge in drug trafficking through Venezuela and into the Caribbean, pushing cocaine to northern markets in North America and Europe. This could complicate economic policymaking and debt management for some of these countries.

Dr. Scott B. MacDonald
The Global Economic Doctor

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