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French elections and currency moves

24 February 2017

What do you think about the French elections and the likelihood of Marine Le Pen becoming President? What are the inherent market risks with her being elected?

If we can take any certainty from 2016, it is that psephologists do not always get it right, particularly when predicting the result of political votes. With that in mind, I fear to tread in the murky waters of political predictions. However, the opinion polls appear to be indicating that Marine Le Pen will be the leader of the first round in the presidential election, but in the second round alternative votes are likely to be concentrated with a single candidate (Macron or Fillon appear most likely) meaning that she will not get elected President. Even if she is elected, unlike Trump, she may not have a majority in parliament which may constrain what she can do.

However, if the polls have got it wrong again there are potentially serious issues to consider. The main problem is that she has expressed the intent to leave the euro. There is no mechanism for this so we do not know how it could work. Past monetary unions have split. Before the First World War Denmark, Sweden and Norway used the Scandinavian Krone and many commonwealth countries fixed their currencies to the pound until this started to breakdown with the devaluation of 1967. In each of these cases countries issued their own currency but at a set rate, in the case of Scandinavia based on a gold standard. Splitting was thus relatively easy. If Brexit is complicated then getting a mechanism to break from the euro may be even harder. Any risk of French bank accounts being redenominated in a devalued currency would be likely to lead to an outflow of deposits.

Any discussion of how a “Frexit” would work is speculation. However, if France was allowed to devalue as sterling has done after the Brexit vote it could be very positive for some French companies. After the initial chaos the French stock market could do well in local currency terms. In the 1930’s the countries that came off the gold standard first tended to be those that recovered fastest from the depression.

Our view remains that this will not happen but we continue to monitor developments closely.

Where do you see the dollar going from here – in particular against sterling, the euro and yen?

Alan Greenspan, when Chairman of the US Federal Reserve, suggested that tossing a coin was as good a way as forecasting currency moves as any. However, currency is a source of risk in most portfolios and many central banks continue to try and influence exchange rates through interest rate adjustments, if not directly in the market. Currencies are often an ugly game in which the least ugly rises to the top. In recent years many central banks have been cutting rates in order to depress their currency and boost their domestic economy. Post the Brexit vote, the Bank of England (BoE) cut rates and with the uncertainty that followed the currency fell sharply. In Japan, negative rates and bond buying have been introduced to boost the economy by depressing the currency to boost exports. The European Central Bank has done something similar.

The US Federal Reserve is the only major central bank to have started raising interest rates and we expect them to continue to do so this year. Better than expected economic numbers and rising inflation make rate rises more likely. Donald Trump’s expansionary spending plans at a time when unemployment is low may add to inflationary pressures. On the other hand, the President has complained that the dollar is too high and this may constrain US exporters.

The direction for sterling may be driven by Brexit negotiations. Inflation is rising as well but this is largely due to last year’s currency move, the oil price and vegetable prices that may all be temporary effects. So far post-Brexit vote the economy has done much better than many people, including the BoE, not only expected but feared. Our exports were up 4% in the last quarter of 2016 off the back of the currency move. However, if we end up with trade tariffs this positivity could reverse and jobs could leave the UK. We believe the BoE will be very cautious on raising rates against this uncertain background. In the event that Britain negotiates a good Brexit deal, we could see sterling significantly higher.

In Japan and Europe, we have seen signs of better economic numbers but the central banks, while they may reduce bond buying, are unlikely to raise rates soon. So interest rate differentials are most likely to move in favour of the dollar and for now we believe that dollar strength can continue despite Trump’s protests. Sterling-based investors have benefitted from the currency moves and whilst our central view is for a positive dollar, investors may wish to take some profits on the currency gains. In particular, we suggest holding European equity on a currency hedged basis. 


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