French Politics and Economics

Understandably overshadowed by the political melodrama in the US, a second round of a local election in France (Brignoles) resulted in a victory by Le Pen's National Front.  The Socialist candidate had been summarily defeated in the first found and the Le Pen candidate thumped the UMP candidate 54%-46%.  The Socialists have been weakened by the poor showing of President Hollande.  The UMP has been weakened by internal strife.

The latest Ifop polls shows Le Pen ahead in the national polls, with 24% support.  The UMP has 22% support and the Socialists 19%. Of note the Socialist are doing worse the Hollande personally, who has a 26% approval rating.      The weekend election is important because it shows that the old reliable strategy to the center-right and the center-left coming together to defeat the far right may not longer be reliable, just old.  Hollande called on his supporters to vote for the UMP candidate in the run-off and it failed to defeat Le Pen's candidate.

Le Pen has honed its message.  On one hand, it outflanks the Socialists in its criticisms of banks and global capitalism.  On the other hand, it outflanks the right with its nationalism,  anti-Brussels's rhetoric and what it calls "intelligent" protectionism.    It also fervently defends the country's welfare model and rejects austerity for the sake of austerity.     While Le Pen has often drawn support from the right, reports suggest it has begun making inroads into the Socialist base and the white working class men and, increasingly women.

Le Pen appears to be in a strong position going into next spring's EU parliament and French municipal elections.   Le Pen wants a referendum on the EU and wants to coordinate an exit from EMU with Italy and Spain.   The argument is that this is a more desirable way to restore competitiveness than the internal deflation that is arguably condemning the region to high unemployment, lower wages and recessionary economic conditions.

There has been practically no perceptible reaction by investors.  The CAC is building on yesterday's gains to record new five year highs today. The 10-year benchmark yield is up 4 bp today, but in line with the rise of the 10-year German bund.  Over the past 3-months, the French premium over Germany has narrowed by 11 bp to about 55 bp.   About half the narrowing of the spread has taken place in the last month.

While US money market funds have rebuilt their European bank exposures, some funds are reducing their French bond positions.  The Wall Street Journal reports today that Franklin Templeton has reduced its holdings of French bonds in recent months.  The rationale cited was yields were too low to compensate for the weakness of the government.  Although exact positions were not revealed, the two funds managed by the head of European fixed income reportedly have divested themselves completely of French bonds.  Other portfolio managers see high yields, better performance, and some suggest more stable politics than France.

Hollande, shortly after his election last year, pledged to keep this year's budget deficit to 3% GDP.   It now looks to be closer to 4% and maybe a little above.  The 3% threshold does not look likely for at least two more years (2015 at the earliest).  For years, the French economy lost competitiveness to Germany, but was able to compete against the periphery.  Now with falling unit labor costs and improving external accounts, France finds itself in a pincer movement.  

                                                      
Japanese investors had been consistent buyers of French bonds, but also appear to have grown more fickle lately.  The latest data shows that Japanese investors have been net sellers of French bonds in two of the last four months (through August) for the first time in nearly two years.  

                         
We continue to see France as key to how EMU evolves. However, we recognize that it did not have the fall of the Berlin Wall that eventually led to Germany's reforms.  Nor did it have the kind of crisis that has forced the periphery to reform.  We recognize France is too strong to be dictated to by Brussels, but too weak to be part of the EMU solution.    At some 30 bp below US 10-year yields, 40 bp below UK 10-year yields  and 185-190 bp below Spanish and Italian yields, we agree that there is limited value left given the broader political and economic context.