Success in the markets requires thinking in possibilities. A great trader understands the permanent information deficit he’s faced with and why it makes market prediction impossible. All he can do is plan for a range of reasonable outcomes and adjust his strategy as new information presents itself.
In the latest issue of our Macro Intelligence Report (MIR), we discussed the reasons for the rise of populism across the Western world and how it’s currently impacting the Soros-style false trend in European equities.
To review, a Soros-style false trend develops when a narrative is founded on untrue assumptions, and yet is so compelling, that price moves in its favor anyway. The positive price action further enhances belief in the narrative and creates a positive feedback loop between market, fundamentals, and narrative strength. This loop continues driving price further away from the truth, creating more instability. Eventually, this loop breaks when belief in the narrative falters and price corrects.
Just as general market prediction is a fool’s errand, so is attempting to predict the end of a false trend. But what we can do is track key events that may poke a hole in the recurring feedback loop. These events are narrative “tests” where should the market pass, the trend will grow stronger, should it fail, the trend may reverse.
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The upcoming test for the European equity rally is the French elections. The outcome of these elections will either strengthen the current European recovery narrative and send prices higher, or dash investors’ beliefs and cause prices to correct.
The reason French elections are key to the current narrative is because of the possibility of populist leaders gaining power — in particular, Marine Le Pen. Le Pen is the leader of the right-wing National Front, an anti-euro, anti-immigration party. One of the main pillars she’s running on is exiting the EU. If France (Europe’s 3rd largest economy) manages to leave, the rest of the union will fall apart. This will quickly negate the short-term reprieve in economic numbers Europe is currently experiencing. The equity rally will quickly reverse as investors abandon the European recovery narrative.
That being said, we believe Le Pen will likely lose.
Populist movements tend to oscillate around secular trend lines. And while the long-term populist trend is up (blue line on the chart below), we’re likely near the peak of the current short-term uncertainty cycle (yellow line). We expect political events to swing back towards benign outcomes for a while (Le Pen losing).
A Le Pen loss should bolster the recovery narrative and push European equities higher.
But in reality, trying to predict elections with high confidence is just like trying to predict markets — impossible.
This is why we understand that a Le Pen loss is only one possibility. And ensuring we have a solid trading strategy requires that we need to look at the other side of the equation — a Le Pen win.
French elections are conducted over two rounds. The first round is set to take place on April 23rd and includes all 5 Presidential candidates facing off. Now if one candidate wins over 50% of votes in the first round, he or she will secure the office immediately. But this is rare. A second round is usually held where the top two candidates with the most votes face off. This will be on May 7th.
The favorite to win the presidency is Emmanuel Macron. Macron was the minister of economy for two years under the previous president François Hollande. He later split off to form his own progressive, pro-EU centrist party. He’s considered the safe bet who won’t shake things up which is good for the economy and the stock market.
The general consensus is that Le Pen and Macron will make it into the second round where Macron will defeat the populist candidate. Current polls say as much:
And the prediction markets also have Macron winning:
But one thing you’ll immediately notice is that the polling numbers aren’t too far apart. Especially in the first round, Macron and Le Pen are neck in neck. And in the second round Macron is by no means dominating Le Pen. The gap between the two is larger in the prediction markets, but these have the tendency to be much more volatile.
So while the media likes to tout a Macron win as a lock, it really isn’t. There’s a legitimate chance of Le Pen winning.
Eurasia Group puts Le Pen’s chances at 40%. Eurasia Group’s founder Ian Bremmer cited voter turnout as a particularly important factor:
Turnout is key. Mr. Macron, who is neither left nor right, and is generally inoffensive to the entire population, is not super attractive to anyone. And so as a consequence, if you get low turnout… Le Pen can win. It’s an actual possibility.
If you remember, part of the reason Trump won the electoral vote in the US is because of lackluster voter turnout. He won after garnering just 26% of votes from eligible voters, less than all 3 previous republican candidates. Low democratic turnout in key states propelled him into office.
The same thing may happen in French elections. Turnout is expected to hit record lows this year. Over 30% of French voters said they’ll abstain from voting in the first round.
This bodes well for Le Pen. Her support base may be smaller, but they’re by far the angriest with the status quo, and therefore more devoted to the cause. They’ll absolutely show up to the polls. As Bremmer said, someone less divisive like Macron doesn’t spark the same kind of devotion. Goldman Sachs strategist Bobby Vedral explained in a note to his clients that if Le Pen can get just 85% of her supporters to show up at the polls (average turnout is 80%), and if Macron only gets 75% of his base out to vote, Le Pen will win the election.
Le Pen voters are also the surest about casting a vote for their candidate. Many of the other candidates’ supporters lean more undecided, meaning there’s a higher chance they vote for a different candidate when it comes down to ballot day.
In general, there’s an unprecedented amount of indecision in this year’s elections. 43% of voters said they don’t know who they’ll vote for in the second round if their first round candidate loses. If those votes swing to Le Pen, she’ll likely win.
And if you move away from the “official” polling, Le Pen’s chances look even better:
Clearly, there’s a decent chance here for Le Pen to take it. This is the reason we focus on possibilities. While we have a gameplan in place for a consensus Macron win, we also wanted to red team that thesis with a potential Le Pen win.
We currently have a basket of European equities we’re tracking that should benefit from Macron winning. But at the same time, we’ve put on a number of option/volatility plays that will profit regardless of who wins. This is important because even though we’re focused on just Macron and Le Pen here, there’s still the chance of a 3rd candidate coming through and sweeping. The polls continue to get tighter and the latest results show the communist candidate Jean-Luc Melenchon surging (because, why not?). And of course, Putin has his hands in this election as well. He met with Le Pen in Moscow last month after previously giving her party million. Anything can happen. And that’s why we stay fallible and make sure to prepare for every scenario.
The above is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.