Frexit – a Brexit with More Bite

With Brexit and the Trump win still reverberating among investors, and a strong Euro-skeptic (to put it mildly) having made it to the final round of the French presidential election, risk managers are once again being asked to come up with a stress (you think?) scenario for the aptly named ‘Frexit’. While the request may be paved with good intentions, it clearly falls into the category of modeling unknown unknowns (and then some). For short horizons, it may be that the best stress test of a Frexit impact would simply be a test that reverses market movements over the past few days, or to retrace the impact of Brexit, substituting France for the UK.

Pitfalls in Stress Test Design
For longer term stress tests, there are a number of potential problems in designing a Frexit stress scenario. For starters, the biggest impact would potentially be on currency risk, but what currency should be used to report potential losses? And what exchange rate should be used for French assets and other euro-denominated assets? Brexit did not confront this modeling hurdle since the pound had a known exchange rate that could be used as a baseline and shocked up or down accordingly (see our previous paper: “Stress testing the impact of Brexit on bonds, equities, and other assets using Axioma’s multi-asset class risk tools”).

Next we must address the (big) assumption that Frexit means only France drops out of the EU. What about other countries, including the possible collapse of the EU itself and the euro as its single currency. If the EU were to dissolve, exchange rates for all the legacy currencies would need to be created, not to mention betas of the non-European currencies to those ‘new’ national currencies. And let’s not forget that it would take years for the euro to dissolve, making it difficult to consider the impact on current investments

Another necessary component of scenario would be a set of probabilities for each outcome. French voters (of which I am one), in their infinite wisdom, have decided to send two polar opposites (at least as in terms of France’s continued participation in the EU) to the final round of their presidential election. According to the latest polls, however, the probability here is nowhere near 50-50, and polls are always correct (NOT!), as the last 12 months have illustrated. Using the latest polls as guide, Marine Le Pen has ‘only’ a 39% chance of winning the presidency in the second round. While that is an improbable possibility, it is not an impossible probability, and some pundits have already described a path for a Le Pen victory (see Roger Cohen’s piece in The New York Times, “France in the End of Days”). Note that many pollsters had Trump’s odds of being elected as much lower. In fact, the outcome of the US election led to much hand-wringing and finger-pointing in the realms of election forecasting.

It’s also about the legislature
But (and it’s a big but) this 39% only represents Marine Le Pen’s chance of becoming president and therefore ‘talking’ about Frexit or a referendum on Frexit, but not of actually ‘doing’ anything about it. The latter is up to the lower house of the legislative branch, France’s National Assembly, whose 577 seats are all up for election in their own two-rounds of voting on June 11 and 18, 2017, mere weeks after the new president elect takes office. In France, the president cannot even suggest laws, pass them through parliament or implement them without the support of the prime minister. And there’s the rub.

As of now, Le Pen’s party (the Front Nationale) only has two seats (of the 289 seats needed for a majority) in the current assembly. Of course, Macron’s newly formed ‘En Marche’ party has none. The two parties that dominate the national assembly – the Socialists (280) and the Republicans (194) – were the big losers of this presidential election, so it remains to be seen if this anti-establishment feeling carries through to the legislative elections. At this point, we have no idea who the new prime minister (leader of the dominant party or coalition in the assembly) will be. Given this situation, what probability should we assign to a ‘Pro-Frexit’ legislative win next month that could support a Frexit proposal? Here again, Frexit differs greatly from Brexit.

Is there a black swan on the horizon?
One thing is certain. While risk managers have been vigorously buffing their crystal balls and gazing desperately in search of defensible assumptions to support their scenarios, investors globally have been betting on a Macron win. Helped by more positive rhetoric around tax cuts in the US by the Trump administration, the reflationary trade is definitively back on this week. As such, the danger may be in the large bet against Frexit being placed ahead of the May 7th result, and the building of a potential black swan event in the case of a heavily discounted, come-from-behind, Le Pen win.

To conclude, even the dim-wittiest quack that’s ever squawked a risk alert can fashion an argument and tell you that only they know what’s going to happen under a Frexit scenario, but the truth is no one does. We can’t even come close to the degree of precision needed to turn this forecast into actionable insight. After the last two sets of unexpected results, Frexit is a word that quickly seizes the imaginations of investors, but remains nothing but an abstraction.

One lesson from Brexit was that uncertainty surrounding the event was stronger than the actual volatility that ensued (and that forecasting the outcome in the event of a “yes” vote was exceedingly difficult). Therefore, we believe a good place to start with respect to Frexit would be to reverse both the Macron and Trump trades, and assume a return of QE programs to quell sharply rising currency market volatility. This would, in turn, be followed by a surge in US treasury bonds, gold, and the Japanese yen (or, for that matter, any safe-haven assets outside of the EU), followed by a crash in the Nikkei, followed by week two, followed by…

(Sigh.)

Consider this. Markets reacted swiftly to the past two surprise votes, and not necessarily in the expected direction. And after that? Sharp reversals in the ensuing months.

So hang on to your berets. This could be a bumpy ride!

Olivier d'Assier

Olivier d'Assier is Head of Applied Research, APAC, for Axioma and is responsible for generating unique regional insights into risk trends by leveraging and analyzing Axioma's vast data on market and portfolio risk. d'Assier's research helps clients and prospects better understand and adapt to the evolving risk environment in the Asia Pacific.