A few thoughts on the 2017 French election & Risk Management

Background:

One of the major “geopolitical” events this year will be the French Presidential election. The first round will be held on 23 April 2017. Should no candidate win a majority, a subsequent final election with the top two candidates will be held on 7 May 2017.

Why bother ?

Well, since I have started the blog, French stocks have been one of the cornerstone of my investment strategy. Despite the bad headline news, I found many good and cheap French companies which contributed significantly to the performance. Currently, I have around 28% of my portfolio invested in France in the following stocks (in % of the portfolio):

  • TFF Group (8,0%)
  • Installux (4,1%)
  • G. Perrier (4,4%)
  • IGE & XAO (2,4%)
  • Coface (3,1%)
  • Thermador (2,9%)
  • Dom Security (2,3%)

The significance of the election

The role of the French President is somewhere in between the US with a lot of power and for instance Germany with almost no power, more on that on Wikipedia.

The “problem” is of course Marine Le Pen, the leader of the right-wing party Front National. Her program among other things contains more or less the “FRexit”:

The EU in the firing line

Le Pen wants France to leave the EU’s Schengen zone, reintroduce national borders and boost customs controls. The most important pledge comes at the top of the list, as part of a bid to restore monetary, legislative, territorial and economic sovereignty: after a period of negotiation, to put France’s membership of the EU to a referendum.

“The European Union is a failure. It hasn’t kept any of its promises, especially over prosperity and security,” she told the party faithful in Lyon.

There are fewer details in her programme over what sort of model would replace it: there is no mention for example, of a previous idea for a pan-European partnership of nation states including Russia.

Likewise, Le Pen has previously been more forthcoming over proposals to reintroduce the French franc. In the 2017 manifesto it is covered in pledge number 35: the “reinstatement of the national currency” dropped in as part of the plan to boost French competitiveness.

Other than the US President, the French President cannot just sign something to get this done, but she/he can call a public referendum which Le Pen promised she will do if she wins.

Normally I would have said that the French are not so stupid to do both, electing Le Pen and exiting the EU, but after last year’s events, I am not so sure anymore. Despite the fact that the participation rate in French elections seems to be very high,  Le Pen plays the full playbook of Trump and UKIP with regard to immigrants “elites”, national pride etc. and one never knows how the dynamics are playing out. Even if it looks very unlikely now, a big terrorist attack just before the election could change the mood significantly.

So I think even as a bottom up investor I do need to think about what could happen because the risk for such a “tail event” is clearly not zero percent.

“Frexit” – What could happen and what should I do ?

If France would actually decide to exit the EU and the EUR and implement the “New French Franc (NFF)”, then one could expect some moderate devaluation (-10 to -20% ?) against the “rest EUR” but in my opinion nothing dramatic. But clearly, economic activity will most likely negatively impacted in France.

The bigger issue is that if France would exit then I guess this would be the beginning of the end of the EU as we know it. Although many people would cheer this, in the end I believe that this would be an overall negative for Europe and a BIG negative for Germany. France is the biggest trading partner of Germany. With the upcoming Brexit, the proposed “Border tax” in the US, a third hit with France would then negatively hit the 3 biggest trading partners of Germany.

Although many people do not believe in such a negative outcome for Germany (“our cars are the best no matter what”), I would not completely rule it out either.

Walk through of my French stocks with regard to potential Frexit issues:

TFF Group: I think this is the company in my portfolio which would see the smallest fundamental effect of a Frexit. Aged wine is a global product with a long history. If for some reasons the stock price would suffer, then this could be a buying opportunity, especially as I trust management to navigate any macro trouble well.

G. Perrier: Domestic player but relatively stable business. No imports, only service. Should be OK. Management has shown that they are able to allocate capital opportunistically.

IGE & XAO: domestic player,  Similar to G. Perrier. However less able to deploy capital like G. Perrier.

Installux: Somehow unclear to me. They are a domestic player and have to import Aluminium but seem to be able to pass through price fluctuations. I bought it as a “super cheap” stock, now it is a “reasonably” priced one.

Dom Security: Somehow higher exposure to Frexit. Large German subsidiary which could be negatively impacted at some point in time. On the other hand steal cheap and solid.

Thermador: Potentially significant impact. They are an importer and depending on building activity in France. However very good management, they might even use this to buy up competitors. This would be one of the stocks where I would add aggressively if the price would come down a lot.

Coface: Trade Credit Insurance is unfortunately the big loser if free trade gets disrupted. In combination with the run up in price toward fair valuation, Coface is a clear sell at this point as the risk/return relationship at this level is not so great anymore in my opinion. I started selling down last week.

Collateral damage Non-French stocks: Pfandbriefbank

Clearly the price of any stock could be affected in an adverse scenario, but unfortunately, Pfandbriefbank might be the one stock which could be fundamentally punished.

Pfandbriefbank has according to its 6 month report, 6,3 bn EUR exposure in France, around 2,3 times their equity. Roughly half of this are loans to French public entities.

Now if France really would switch to NFF, the question is: What will happen to those loans ? Will the remain in EUR or will they forcibly be switched into NFF ? The second option would be really bad for PBB because all their liabilities will remain in EUR.

My assumption is that the risk relates to law applicable of the contract. So  a contract under German or UK law could not simply changed to NFF, but a contract under French law maybe could. I think it will be very hard to find out about this and I am not sure if they would answer this question. In any case, Pfandbriefbank clearly adds to my exposure which then is around 30% of my portfolio.

Portfolio/Risk Management

Overall, a 30% exposure of my portfolio exposed to a French tail event is clearly too much (for me).So what to do now ?

When I learned sone thing during 6 years writing blog then it is the following:

I am relatively good at holding through stocks in times of turbulence if I have trust in the company, the management and the business. However I am relatively bad a keeping positions which I bought for counter cyclical reasons or just because they were cheap. I tend to sell them at the exactly wrong time.

Therefore it makes sense to sell those positions first where I am not 100% sure that they will manage to get through any kind of crises.

In my case this then leads to the following transactions

  • complete sale of Coface due to the reasons explained above (reduction by -3,1% of portfolio exposure)
  • reduction of Pfandbriefbank by -1,8%
  • reduction of installiux and IGE & XAO  0,5% each

This will bring me to below 25% of direct exposure to a French tail event which I think I can live with for the time being.

This alos increases my cash holding to around 9% which is within my “tolerance” and without being a big market timing call. I do have some ideas where to invest this already….

29 comments

  • Sold my remaining Pfandbriefbank shares today.

  • Sorry but you are too complacent here. If Marine passes, this is major wave of depreciation of all EUR assets. I’ve bought in 2012 and steadily decreased exposure since then. Still run EUR/USD short.

    I guess that investor do not want to wonder what would the EUR – french franc conversion. That being said, this is a medium to low probability outcome.

    • As a EUR based investor with most of my expenses in EUR, I have a “natural hedge” to a certain extent, US based investor might see this differently.

      As I said, i think most of my EUR denominated stocks are quality businesses which should do OK even under adverse conditions. My overall EUR exposure is (incl. cash) at 60% which for me is pretty OK. I also see some significant upside if Le Pen doesn’t win and the begining EU recovery is getting under more steam.

      • Ok, so that is the point: can the EU finally return to positive trend given that it is almost 5 years this should have happenened. and 2. the underlying trend is anti-globalisation ?

        • This is exactly the question. A lot of European equities are priced as this will not happen. Which then again implies a potential upside. From my point of view, things look actually quite promising from a fundemantal point of view. What remains is the significant political risk.

  • Last but not least: south of France there are also (heavily) underestimated risks…

  • Also I would accordingly prepare for opportunities in case of black swan comes (I guess that is what you say investment opportunities). Btw, if Frexit materializes, the Repubkic of France is still liable to sovereign debt denominated in the original currency, right ?! Regardless of the intro of NFF, I mean…

    • I am not sure. I think they can converrt the currency of their obligations if the issued debt is according to French law.

      • I would say they would not be able to reset them in NFF. And even if they would do, which fx would they take, an artificial one? If conversion would be at market rates then you debt could be swapped to eur with no material impact. Still, I think liability would be denominated in EUR. Of course that is stg LePen and its followers cannot understand (too complex for their small brain).

        • well, if the debt woul dremain in hard currency, then why bother with the NFF ? And of course would the exchange rate be an artificial one. And I do think they understand this very well.

        • There is internal debt, mortgages etc, under French jouristiction and external under future joint or French jouristicion?

        • I am not sure what you mean with “internal” debt,

          Here is a Reuters article which confirms my view:

          http://www.reuters.com/article/france-debt-idUSL5N1EV182

          Lawyers contacted by Reuters said the government could convert its existing debt into a new French franc without major legal challenges.

          “Given that most French government debt, if not all of it, is governed by French law then that would be an easy change for the government to make,” said Matthew Hartley, a debt capital markets partner at London-based law firm Allen & Overy.

        • My apologies.

          I meant transactions where French entities that borrowed from other French entities in the French legal domain. Then other than transactions involving foreign entities. That would have been using two overly simplistic categories. But, it is so much more complicated than that.

          Good question. I did not realize used a term that exists with an other meaning than mine*.

          I could not guess how to react with investments. It seems so complicated and I suspect more so to me due to ignorance.

          My comment does not merit much time due to unfortunate ignorance of France and the importance of your investment issue. You have skin in this game I do not. You seem much more clued into this and experienced than me and better read. I’m still groping around to understand this sort of thing.

          And what follows is me and my big mouth going on when I should have stopped there.

          I think any thing might be tried by fiat with strokes of the pens. They could do well, muddle along, or really screw some thing up. Ancient, (by US standards), Italian banks have gone bankrupt lending to defaulting Kings.) Of, course a change in currency is not a total default.

          In Greece and Cypress the bank depositors, bond holders, stock holders paid, and economy paid. And ,I think the ECB got paid first or second what could be paid.

          Expert leaders might do better than ignoramuses. Experts might not, or might not be expert enough.

          Based on early United States history quite a few founding father’s verbiage was to make good on government debt in order to preserve future credit. Many of those people were involved in business or trade and there were times when the economy heavily depended on credit due to lack of hard currency. In fact, sometimes the colonial economy flourished exploiting necessary credit countering a lack of hard currency. If the entities (government) are smart they might value their credit reputation. In order to have credit, to keep on rolling all their debt over. Often more than 90% of money supply is credit money (ie Greek and Cyprus bank holidays).

          Did or could Greece, Cypress, or the Eurocrats and voters do the smartest thing? If France have a higher position than Greece or Cyprus and maybe they will do better. But, is France on top? I do think the French have had a history brilliance. I even wonder if Italy has an edge or some thing up their sleeve because of their accounting and banking history might lead to prowess? But, that is wondering and not knowledge.

          *https://en.wikipedia.org/wiki/Internal_debt This is not what I meant.

        • Good article. I suspect many creditors thing this way, expressed in the article.

          “Ultimately the credit consequences would depend on whether we concluded that investors would still get back what they expected, when they expected it. If we not, we would likely call that a default,” said Alastair Wilson, managing director of sovereign risk at Moody’s.

  • Great post.
    Wouldn’t your banks suffer also a bit too, mainly following disruption in financial markets and credit risk ? … I guess Admiral also has some french exposure in their replicating portfolio?

    • hmm, I think Admiral doesn’t have a big replication portfolio as most of the premium goes to Reinsurers anyway. And yes, the stock price would be affected of my bank holdings, but fundamentally they should be OK. I hope…

  • “Other than the US President, the French President cannot just sign something to get this done, but she/he can call a public referendum which Le Pen promised she will do if she wins.”

    The president can not call for a public referendum without a parliamentary majority. Ie LePen can do nothing unless she wins a majority at the legislative elections on June 11th and 18th or can somehow get one for that referendum.

    Now, while there is a small chance of her becoming president, there is an even smaller chance of her winning a parliamentary majority (we’re talking about some 0.0x% chance). Assuming that she could pull off that miracle, between 65% and 70% of the French people think that France is better of within the EU and with the Euro.

    Going into panic mode and selling French assets now? I’m very surprised to see you going down that road. I actually thought you’d go bottom fishing …

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