Markets cheered the prospect of an Emmanuel Macron presidency, but even if he wins, his reforms may lack parliamentary support. As a result, Franck Dixmier says the risk aversion of recent weeks could last until France's legislative elections in June.
The worst has been avoided
From the financial markets' point of view, the worst has been avoided in the first round of the French presidential elections. The prospect of Marine Le Pen securing a very high share of the vote – and the potential for a second-round runoff between Jean-Luc Mélenchon and Ms. Le Pen – had led to increased risk aversion in recent weeks. This logically benefited German bunds more than all other fixed-income assets in the euro zone.
Although we are not surprised by the markets' initially positive reaction to the fact that the euro-phobic French presidential candidates fell short of expectations, we are nonetheless wary of how sustainable this fresh rise in the markets' risk appetite can be.
Risk avoidance in recent weeks has benefitted German bunds more than other European fixed-income assets
Opinion polls for the second-round runoff between Emmanuel Macron and Ms. Le Pen are indicating a very likely victory for Mr. Macron, which is so far being reflected in the markets. Calls from the former governmental parties' candidates, François Fillon and Benoît Hamon, to vote for Mr. Macron against Ms. Le Pen have added weight to this potential outcome.
If this scenario were to hold, France's legislative election in June would be the most important event on the horizon – and there are major questions over the shape of the potential majority with which Mr. Macron would be able to govern. Although he is on the verge of achieving an incredible accomplishment as the youngest-ever elected president – younger even than Louis Napoléon Bonaparte – it is far from certain that the momentum sweeping him into power would be strong enough to ensure a parliamentary majority. If his party fails to secure this majority, which cannot be ruled out, or if he needs to rely on cross-party backing for the approval of specific projects, Mr. Macron's reform-minded ambitions would be significantly curtailed. This would undermine the fresh momentum he intends to give to the European project.
France's legislative election in June could be the most important electoral event on the horizon
As a result, we would wait until after the legislative elections to adjust our positioning among risk assets. Once the "French risk premium" dissipates, all euro-zone spreads should benefit, and nothing aside from persistent geopolitical risks should prevent the overvaluation in bunds from correcting.
Beset with low rates, slow growth and a new US president who wants a significant shift in policy, the Federal Reserve faces one of the most uncertain periods in its 104-year history. What could a changing Fed mean for investors?
Changes afoot at the Fed
The election of President Donald Trump has already had significant implications for many US institutions – from the Supreme Court to the Board of Education – and the Federal Reserve is next in line. A complete revamping of the country’s central bank will start to play out over the next 12 to 15 months.
During that time, the Federal Reserve Board will likely welcome five or six new governors, implement new approaches to monetary policy, take a looser regulatory stance, reduce its portfolio of assets and potentially encounter unprecedented oversight by the executive branch. Taken together, these shifts in direction will provide an important reminder that while the US central bank is “independent within government”, as it is often described, it is not “independent from government”.
Existing legislation empowers Mr Trump to appoint Fed governors who favour policy adjustments that are in line with his administration’s goals – and he will certainly have several opportunities to do so. By stacking the Fed’s Board with like-minded governors, Mr Trump can weaken the Treasury-Federal Reserve Accord of 1951, which freed the central bank to formulate monetary policy regardless of the wishes of the president.
At the same time, the Fed’s independence from political interference will not be entirely eroded. The Fed will likely take symbolic actions that add to the transparency of its operations, and unless new legislation is enacted, there should not be meaningful changes to the structure of the Fed system.
Investment implications of the new Fed
- Faster and higher interest-rate hikes. New Fed governors will likely resemble other Trump administration officials – for example, business executives who dislike excessive regulation. We also expect the next Fed Chair to favour a strict, rules-based approach to monetary policy formulation and implementation. This is a marked departure from the view of current Fed Chair Janet Yellen, who vigorously opposes such an approach. Given that most of the current 17 members of the Federal Open Market Committee believe US interest rates are too low to stimulate enough real economic activity, a newly revamped Fed may elevate rates as quickly as economic conditions allow. Rules-based models suggest that the FOMC could feasibly raise interest rates to 4 per cent soon. Investors may want to consider factoring this forecast into their asset allocations – particularly given that many bonds lose value as interest rates rise.
- A shrinking Fed balance sheet with limited market disruption. The weighted average maturity of the Fed’s balance sheet has shrunk considerably since its peak in January 2013. Although it is unlikely that the Fed’s portfolio will be reduced to its pre-financial crisis levels, we expect the Fed will begin unwinding its positions later this year as the federal funds rate approaches its target level. Recent hints by FOMC members suggest that they will reduce holdings of both Treasuries and mortgage-backed securities. Investors may be reassured by the fact that because the Fed has preannounced its intentions, it is unlikely that these portfolio reductions will significantly disrupt the markets or have an outsize effect on interest rates.
- Reduced regulatory burdens to spur growth. The resignation of Governor Daniel Tarullo, the Fed’s head of supervision and regulation, enables President Trump to nominate a successor who will relax enforcement of existing regulations, roll back others and, perhaps, guide the withdrawal of the US from some international banking standards. Look for the Fed to either withdraw from Basel IV capital standards negotiations or, at least, to attempt to impose US-favoured rules. Other international standards covering leverage, solvency and liquidity could be modified or put at risk. This may mean that small regional and community banks can look forward to diminished regulatory burdens. This could give them more scope to lend money to local businesses, which could in turn spur some economic growth.
For more information, read “The End of the Fed as We Know It?” on allianzgi.com