Macron came out ahead of the first round of the French presidential election, gaining a 24% vote share. Even though he was only three percentage points or so clear of his closest rival, Le Pen, given Macron’s huge lead in the second round head-to-head polls (some 20 percentage points versus Le Pen), and the endorsement of his presidency by losing candidate, Fillon, and current President Hollande, he is far and away the favourite to become the next President of the French Republic.
Given the French opinion polls were correct – impressively so, one might add – implying that the outcome of the first round vote was broadly in line with investors’ prior expectations one might have expected the market reaction to have been relatively contained. However, that was not the case.
French equity prices rallied over 4% in the first couple of trading sessions following the result with global equity markets following suit, in many instances breaking to fresh cycle highs. Such a positive reaction to what was the baseline scenario for most investors, was, however, consistent with our expectation as outlined in a recent article.
“As long as Macron makes it past the first round then he will almost certainly come out as the overall victor – our expectation. At this point, the risks embedded in the crowd’s current thinking, and reflected in the pricing of French financial assets, should be rapidly unwound, setting the stage for a solid rebound.”
What this episode clearly illustrates is that one cannot fully understand market dynamics based purely on the consensus or median market expectation, investors need to make a more comprehensive assessment. Ex ante every possible out-turn has a probability attached to it and also an expected market impact (when multiplied and summed this equates to what economists call expected value), something that only crystalizes ex post.
An Expected Outcome
In the case of the first round vote, while Macron was favourite to win ahead of Le Pen in second place, investors attached nonzero probabilities to other possible vote permutations and hence alternative second round candidates.
Not all of these combinations would have been bad. For example, Macron/Fillon would have been the most market-friendly outcome. However, given the way the French options markets traded into the vote it is clear that investors were hedging the downside risk of an unfriendly market outcome, most notably Le Pen/Melenchon, which would have been a veritable market disaster given the likely Eurosceptic bias of the next French leader.
The VIX equivalent for the CAC40 increased by almost 10 big figures between the start of April and the eve of first round vote – a move that was fully unwound in the past few trading sessions – see exhibit below.
Exhibit 1: One-Month Implied Equity Vol vs. Crowd-sourced Fear Sentiment – France
Contrast this with the move in the crowd-sourced Fear for the CAC40. This sentiment indicator peaked at a record high (the indicator is calibrated to range between 0 and 100) in late March and then declined steadily to around 60 just prior to the election. Still elevated by historical standards but nevertheless significantly lower. Notably, the reduction in crowd fear towards French equities mirrored the fall in government anger sentiment in France, which as detailed in the aforementioned article, is one of the primary indicators one has used to successfully track political votes over the past year.
Such divergence between market prices and crowd sentiment is fairly strong evidence that investors were unduly bearish going into the first round vote, either by overestimating the odds of a market-unfriendly outcome or overestimating the impact of a market-unfriendly outcome. And, once the downside risk dissipated, this provided the scope for a significant market repricing – upwards.
Following the “surprise” vote outcomes of last year, namely Brexit and Trump, it is not at all surprising that investors collectively were more cautious in this election – that is human nature. But, this overcompensation is what created an exploitable alpha opportunity.
Looking ahead to the second round, as already noted, based on the second round polls Macron is the overwhelming favourite to succeed. But, as in life more generally, anything is possible. Hence, some residual caution is likely to persist until the second round vote, which is entirely consistent with Fear sentiment towards French equities still being somewhat elevated.
Why the Polls Are Not Wrong
That said, government anger sentiment in France has continued to subside subsequent to the first round vote, suggesting that Le Pen is not gaining momentum against Macron, and certainly not to the extent that would imply the opinion polls are seriously wrong. Combined, this suggests to us that the price outlook remains constructive. In short, one sees no domestic political reason to consider fading the rally in French equities.
One was careful in wording that conclusion, because there are clearly other risks, unrelated to French domestic politics, that could be the catalyst for French equities turning down. In addition to the rather obvious elevated geopolitical tensions between the US and Russia over Syria and the US and China over North Korea, there is also renewed worries about the outlook for the Chinese economy – still a key driver of global growth.
Given the widespread scepticism regards the accuracy of official Chinese GDP data, recently published Q1 GDP numbers showed economic growth accelerating to 6.9% y/y, investors very often use alternative proxy indicators to gauge the “true” trajectory of the economy. This can include unofficial PMI surveys, electricity usage statistics and even selective asset prices, especially commodities. One classic example is iron ore.
Effect on Commodities
Back in February, confidence in the outlook for iron ore prices was extremely elevated – in fact, crowd sentiment was so high that it made it into our top most loved/most hated candidates in the first article published this year. The contrarian view that this commodity price was due to reverse its uptrend – a concept denoted as “crowd fail” – was a little pre-emptive: prices continued to rise until mid-February, hitting almost $100 per tonne. However, since they have plummeted almost 20% – a sizeable move by any standard and certainly one that catches the eyes of investors, including those focused on China.
As the orange line in the exhibit, crowd sentiment towards iron ore has slumped but, importantly, remains in positive territory. Certainly, it cannot be considered in any sense extremely negative, i.e. the mirror-image of conditions at the turn of the year. Hence, this is a warning that the downtrend may not yet have run its course.
Exhibit 2: Crowd-sourced Sentiment – Chinese Growth vs. Iron Ore
The second line in the above exhibit shows the evolution of crowd-sourced sentiment towards Chinese economic growth. The two sentiment indicators tend to track each other reasonably closely, so it is not that surprising investors join these two dots, so to speak. Moreover, on the back of official measures to dampen speculative excess, Chinese equity markets (another most loved candidate in the aforementioned article considered vulnerable to the downside) have corrected lowered over recent weeks, concomitant with a downward move in crowd sentiment – see exhibit below.
Exhibit 3: Crowd-sourced Sentiment vs. Price – Chinese Equities
Given the sharp correction in iron ore price (ditto for copper – see footnote 9 above) and the recent equity market wobble, it is not surprisingly that investors are becoming more cautious regards the outlook for the Chinese economy. However, at present, there is no evidence of this filtering through into the broader crowd with growth sentiment in China best described as modestly positive.
Well, at least, not yet.