Political Risks Facing Equities (Le Pen & Debt Ceiling)

In this article, I will review the political risks facing the market. The two most pressing issues facing the market are the French presidential election and the potential issues surrounding the debt ceiling in America. Both have the potential to cause volatility in the equities market if they turn out to have unforeseen outcomes. The fat tail event in the French presidential election would be if Marine Le Pen wins the election. The fat tail event in the debt ceiling situation would be a repeat of the 2011 scenario where S&P downgraded America’s debt rating and there was a government shutdown. I think neither of these risk events will occur, but since they are generating chatter in the media, it’s worth discussing them. If any news comes out which pushes the odds of these events higher, the market will fall.

In recent reports, I’ve seen some commentators explain that Marine Le Pen winning the election doesn’t necessarily mean France will leave the Eurozone. Technically that’s correct, but she’s promising a referendum if she wins, so it’s highly likely. The two hurdles that need to be overcome are parliament needs to grant her the referendum and the people need to vote to leave. If she wins, those same voters who supported her will support the referendum, so it’s likely that France would vote to leave the EU. The parliament will support this referendum as they will want to listen to the will of the people. I’d say that there’s a 95% chance France will leave the EU if she wins the election. The fact that commentators are trying to downplay her victory signals to me her odds have increased.

To summarize the French election, I’d say Marine Le Pen’s chances of winning have gone from impossible to improbable. This improvement in her chances is why CNBC ran the headline that said the market rallied despite French election fears. It’s also why the French 10-year bond yield sold off as you can see in the chart below. It’s 10 basis points off the high earlier this month, but it still shows the risk being priced into the bond market.

The French election reminds me of the recent GOP presidential primary because of the number of candidates running. The GOP primary had 17 candidates. The politics behind who would drop out of the race and when they would drop out was critical because it affected the outcome of the race. In theory, if some of the conservative candidates dropped out earlier, Cruz could’ve had a better shot at beating Trump. There are 11 candidates running in the French presidential race. The chart below shows them all, along with their level of support in the recent polls. As a reminder, the French election has two rounds. The top two in the first round face off in the second round. Like the GOP primary, there has been some recent gamesmanship by the candidates to try to coalesce their support to have a better shot at winning.

The left-wing candidates, which are getting little support, are thinking of joining forces. The candidates who want to join forces are Hamon, Jadot, and Melenchon. If this occurred, it would shake up the election. If you add up their percentages in the latest poll (14%, 2%, 11.5%), you get 27.5%. This combined force of the left would put it into the lead. This situation has a twofold negative effect. The first is that the market doesn’t want these left-wing candidates to win, so if it is the left versus the far-right Le Pen in the runoff, it is a lose-lose scenario for the market. The second negative is that Le Pen would have an easier time beating the left-wing candidate than a centrist candidate.

As a reminder, the market wants either Macron or Fillon to win. Maybe they can combine forces as a response to the left’s coalescence to fight them off and get a candidate into the runoff election. Even without the left joining forces, the odds for Le Pen were already improving. Fillon has gained ground in the polls and is now tied for second place with Macron. Le Pen does much better in her match up with Fillon than her matchup with Macron. This is the reason I said her chances have improved to improbable. In the last head to head matchup with Macron, Le Pen loses by 24 points. In her last matchup with Fillon she loses by only 12 points. It’s possible that if Le Pen wins the first round, she can gain momentum in the race and outperform her polling.

Arun Kant, executive and chief investment officer at Leonie Hill Capital, built an AI system which incorporates data such as social and traditional media discussions, polling, economics and demographics which is predicting a narrow victory for Macron. However, because Le Pen will gain momentum from winning the first round, Kant is overruling his AI system and saying he thinks Le Pen will win. The system predicts in the first round Le Pen will get 28%, Fillon will get 16.4%, and Macron will get 19%-20%. In the second round, it says Macron has a 52.3% chance to win and Le Pen has a 47.7% chance to win.

I think the debt ceiling issue is much to do about nothing because the GOP controls Congress. Secondly, the Democrats were arguing in favor of raising the debt ceiling in 2011, so I doubt they would try to use the GOP’s tactics against it. The media has reported that there are different opinions in the Trump administration about how to respond to this issue. Treasury Secretary Mnuchin says paying the debt is a “critical commitment” while the head of Office of Management and Budget Mulvaney doesn’t see the need to raise the ceiling and supports prioritizing debt payments over other federal obligations. I think this issue is a problem with messaging. Trump was put in a tough situation of having to deal with this problem early in his term. I doubt the administration would be against raising the ceiling, if raising it would be easy.

The suspension of the debt limit expires March 15th. If the ceiling isn’t raised by March 31st, the Treasury will deploy “extraordinary measures” which means taking actions such as delaying contributions to a retirement funds for federal employees. This will allow the government to run until September. I think the tax plan will be signed into law by September, so even if no action is taken before then, the situation will be fine. If there aren’t any credible calls by politicians to prevent the ceiling from being raised, I don’t think the market will care when it is raised. The only reason why it fell in 2011 is because some politicians were claiming they didn’t care if the U.S. defaulted on its loans

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Don Kaufman: Trade small and Live to trade another day at Theotrade.