France's Two-Round Electoral System Spells Volatility for Markets

For investors, elections in France are just different: a two-round system that lets them shift bets, reassess polls and scout for bargains.

And for the presidential vote that kicks off on Sunday, things could be particularly volatile in the two weeks between rounds, some investors say.

In the mix are candidates from the far-left and far-right who promise policies that if enacted would have far reaching effects on European markets, making this election of interest far beyond France. Investors are particularly concerned about Marine Le Pen, an economic nationalist who wants to pull France out of the euro--potentially signing the end for the single currency.

That has sent global investors scrambling to learn about the French electoral system, which establishes a runoff between the two most popular candidates if nobody wins half the votes in the first round.

That interregnum is "likely to be peak uncertainty," said Thomas Clarke, a fund manager at William Blair & Co., a Chicago-based asset manager that planned to scoop up cheap French and Italian bonds if turmoil ensues.

"We think this is potentially going to open up an opportunity," he said.

Polls currently predict that Ms. Le Pen will face one of two centrist candidates in the second round on May 7. But in recent weeks, Jean-Luc Mélenchon, the left-wing firebrand who promises higher wages and fewer working hours, has soared in opinion polls, setting up a potential showdown of political extremes.

So investors are particularly unsure about who will face off in the second round, promising a flurry of action after this Sunday's vote.

Options that insure against swings in stocks in the Euro Stoxx 50 index show that investors are more protected against the first than the second round, according to Macro Risk Advisors. These derivatives predict a 3.5% move in the index in the week after the first vote and only a 3% move after the second.

"It signifies that we could see a high volatility period after the first round depending on the voting results." said Pravit Chintawongvanich, MRA's head of derivatives strategy.

Markets currently are only pricing in a small probability that Ms. Le Pen could win.

Stocks have been mainly unruffled ahead of the election. The extra compensation investors demand to hold 10-year French government debt instead of German paper has risen to 0.66 percentage point, compared with 0.22 in September, but even that strikes some analysts as a small spread given Ms. Le Pen's threat to the eurozone. The euro itself is up against the dollar in the year to date.

According to polls, Ms. Le Pen is currently neck and neck with centrist Emmanuel Macron with around 25% of the vote each. Polls go on to predict that Mr. Macron will get two-thirds of the vote if he meets Ms. Le Pen in the second round.

But investors point out that over the past year, pollsters failed to predict Britain's Brexit vote or Donald Trump's election victory.

This leaves potential for the largest market gyrations to happen after Sunday's round, analysts say. If Ms. Le Pen does particularly well, her views on the euro could trigger outflows of money not just from France, but from weaker eurozone economies like Italy, Portugal and Spain.

M&G Investments, which manages GBP265 billion ($339 billion) in assets, has prepared by increasing their holdings of easy-to-sell assets and reducing exposure to long-term bonds, said Nicolo Carpaneda, an investment director in the London-based group's fixed-income team.

A better-than-expected result by Ms. Le Pen could also boost German bonds as a haven, he said.

For investors, even if Ms. Le Pen makes it past the first round, failing to predict who she will meet in May could have big consequences.

If it is Mr. Mélenchon, that sets up a far-left versus far-right runoff that is investors' worst nightmare. If it is conservative candidate François Fillon, whose candidacy was hit by a scandal surrounding the employment of his wife, polls predict he would do worse against Ms. Le Pen than Mr. Macron.

The French turned to a two-round vote in 1962, basing it on a system that used in Germany between 1871 and 1918. Political analysts credit it with stifling the chances of radical candidates, but research also shows that it can also increase uncertainty, as voters shift unpredictably or decide to vote in only one of the two rounds.

Some investors, though, believe the system, and the chance of victory in the early round, has merely given an unrealistic impression that Ms. Le Pen could win power. If the first round confirms her chances are slim, expect a relief rally, they say.

"Between the two rounds, if it looks like Le Pen isn't going to win, it might be a good moment to get back into European stocks," said Bob Baur, chief global economist at Principal Financial Group, which manages $592 billion.

Write to Jon Sindreu at

(END) Dow Jones Newswires

April 21, 2017 08:18 ET (12:18 GMT)