France’s April 23 presidential election looms as the next important test for the future of the European Union and its common currency, the euro. The questions for institutional investors: What is the risk of France quitting the eurozone and what are the implications for their portfolios?
Using our stress testing capabilities, we model potential market reaction to three possible scenarios. One scenario models the impact of a 70% chance that France leaves the eurozone, resulting in an immediate 13.2% potential loss for a globally diversified equity portfolio.
Why markets are nervous
In reality, the chances of France abandoning the euro, if not the EU, are small. But the consequences are so severe that the possibility has made investors skittish about French equities and bonds.
Many observers believe a Frexit could lead to the end of the EU. In addition, France would have to resurrect the franc, a much bigger task than that facing Britain, which has never abandoned the pound. A de facto default on French government bonds could occur if France refused to pay its obligations in euros.
We have modeled market reactions to three possible post-election scenarios, two of which involve potential ramifications of the increased likelihood of a Frexit occurring. A third assumes Frexit becomes very improbable, and markets regain losses already priced in, particularly in French government bonds.
Each scenario imagines a series of shocks that we apply to hypothetical globally diversified equity and bond portfolios1 using MSCI’s stress-testing capabilities.2 Markets would be expected to price in new perceptions almost immediately.
The scenarios produce potential outcomes for a globally diversified equity portfolio that range from a 13.2% loss to a 3.8% gain in U.S. dollar terms. A global government bond portfolio, on the other hand, could lose 6.2% in the most severe Frexit scenario but could gain 0.7% in the rebound scenario (in U.S. dollar terms).
High probability of a Frexit
The first scenario models high post-election expectations of a Frexit, prompting markets to price in a 70% probability of a eurozone breakup. The impact of Frexit has two components. First, we quantify the macroeconomic impact of a eurozone breakup1 on financial markets. Second, we impose specific shocks to peripheral country spreads, French equities and European financial equities, VIX implied volatility and the euro/U.S. dollar exchange rate. Whereas the French equity shock is based on its beta to the French sovereign spread, the other shocks are calibrated to the Greek default crisis of 2011-12.
Under this scenario, French equity prices could lose 40%, whereas European and U.S. equity markets could fall by 13% and 9%, respectively. European financials could take a 28% hit, underperforming the broad European market, driven by an increase in systemic risk. French and Italian spreads over the German 10-year yield each could widen by 250 bps, and the German 10-year yield could tighten by 45 bps. Implied volatility, as measured by the VIX, could spike by 30 percentage points, and the euro could weaken 14% against the U.S. dollar.
- A globally diversified equity portfolio could lose 13.2% (in USD terms) on average, with large differences among geographical regions. The periphery of Europe could lose around 31%, whereas losses for the core countries could amount to 12% (in local currency).
- Peripheral European government bonds could take a large hit, with French, Spanish and Italian bonds losing around 12% (in local currency).
- Core European government bonds could diversify, with German and Dutch bonds both gaining 1.9% (in local currency).
- Non-European government debt could act as a safe asset, with U.S., Australian, Canadian and Japanese government bonds gaining 2.1%, 2.9%, 1.9% and 0.6%, respectively (in local currency).
Low probability of a Frexit
Under this scenario, markets price in only a 30% post-election chance of a Frexit. French stocks could fall 18%, European equities could drop 5% and U.S. stocks could fall 4%. Looking at European sectors, European financials are the most vulnerable, potentially declining 12%.
The French and Italian spreads over the 10-year Bund yield could spike by 110 bps, while the Bund yield itself could tighten by 20 bps. Implied volatility could jump by 13 percentage points and the euro could lose 6% against the U.S. dollar.
- A potential loss of 5.9% (in USD terms) for a globally diversified equity portfolio. In local currency, European peripheral countries could lose 14% and core countries 5%.
- Peripheral European government bonds suffer most. French, Spanish and Italian bonds could fall by approximately 5.5% (in local currency).
- Core European and non-European government bonds could provide diversification, with German, Dutch and U.S. bonds potentially gaining 0.9%, 0.8% and 1%, respectively (in local currency).
Though a Frexit is not viewed as likely, markets have partially priced in its possibility, as prices for French government bonds and equities have declined. A rebound could result if the prospects of a Frexit are deemed virtually non-existent following the elections.
To gauge how much a potential Frexit has been priced in, we compare the French yield to the 10-year German yield. The spread between these two spiked earlier this year when uncertainty about a potential Frexit was increasing. If a Frexit becomes unlikely, we assume the French spread would tighten by approximately 40 bps, offsetting prior spread widening. Linking this spread change to French equity returns, based on a long-term beta, our stress test scenario assumes that the French equity markets could rally by 6.5%. There is little impact on the euro/U.S. dollar rate.
- A globally diversified equity portfolio could gain 3.8% (in USD terms). Both core and peripheral European countries could benefit, with gains in local currency of 5.7% and 6.6%, respectively.
- In the fixed-income segment, the largest gains could be in peripheral European government bonds. For example, French, Italian and Spanish government bonds could increase between 2% and 3% in value (in local currency).
- The impact on core and non-European government bonds could be negligible.
1 We assess the implication of the stress test on a global portfolio of stocks (represented by MSCI ACWI) and a global portfolio of government bonds (proxied by the JP Morgan Global Government Bond Index).
2 Analytics from MSCI include RiskManager, BarraOne, and MSCI’s Macroeconomic Risk Model and Scenario Analysis Service. Clients will find guidance on how to implement the stress tests in RiskManager and BarraOne at our client support site.
3 We adapt the macroeconomic assumptions from Cliffe, M. (2011). “EMU Break-up: Pay Now, Pay Later.”
ING Financial Markets Research. These macroeconomic assumptions are propagated to equity and bond markets, using the MSCI Macroeconomic Risk Model.
The author thanks Carlo Acerbi for his contributions to this post.