Friday April 21

Stock prices finished lower as investors are looking ahead to the French elections over the weekend. The S&P 500 fell 0l3% to 2,348 and the Dow Jones fell 0.2% to 20,547. Over the course of the week the S&P 500 was 0.8% higher and the Dow was 0.5% higher. Today the KBW Bank index lost 0.8% while utilities rose 0.7%. Investors aren’t pricing in too much fear ahead of the election over the weekend as the CAC 40 in Paris rose 1.4% today and the euro rose 1% over the week. The worst possible outcome for investors would be Le Pen and Mélenchon advancing to the second round of elections. Investors today didn’t draw too much optimism from Steve Mnuchin’s comments saying that tax reforms would be revealed “very soon”. On a similar note Donald Trump said that constituents could expect a “massive tax cut” as soon as next week. Yields in the US remain low in spite of the fact that the Fed hasn’t changed its dialogue much in recent weeks even as rates have rallied. On that backdrop the two year Treasury yield fell 1bp to 1.19%. The ten year Treasury yield rose 1bp to 2.25%. Accordingly 2yr vs 10yr steepened to 1.06%. The dollar was weaker for the most part against peers. USD fell 0.1% against EUR to $1.0727. USD fell 0.2% against JPY to Y109.07. USD was little changed against GBP to $1.2812. Oil prices suffered a heavy drop as investors are reconsidering resilient supplies in the United States. WTI fell 2.1% to $49.63. Brent fell 1.8% to $52.05.

The relatively sanguine market pricing of the French election suggests that investors are anticipating a second round to be decided between Emmanuel Macron and Marine Le Pen. In France’s election process there are two rounds of elections and the first round narrows the candidates down to the final two. Currently Macron is polling at 24%, Le Pen 22%, Fillon 19% and Mélenchon at 19%. If a specific candidate gets more than 50% of the vote then they would win outright but that doesn’t look like a possibility right now. It is expected based on polling data for the second round that Macron would win a showdown with Le Pen. To reflect these expectations French stocks and the euro both had a strong week. The spread between French and German bunds tightened to 60bp from 78bp as recently as last week. That level is still elevated however compared to last summer before investors began to price in political risk in France when the spread was just 20bp. Additional the euro risk reversal, which shows how expensive euro puts are relative to calls is at the highest level on record. If Le Pen does in fact win the election that would be arguably worse for Europe than the Brexit since France is a more integral part of the currency union. Researchers at UBS estimate that if Le Pen won then European stocks would lose 7.6% and bunds and Treasuries would rally. Marine Le Pen has said she would take France out of the euro and return the use of the franc, which would constitute an act of default. It would also threaten peripheral countries that benefit from the euro currency union since the viability would be called into question. French banks would underperform since they are most exposed to business relations in the euro area. Additionally a large portion of French government debt, around 60% is held by international investors who are more likely than domestic institutions to sell in times of uncertainty. Other investors argue that even if Le Pen wins she wouldn’t be able to accomplish much since she would also need the support of the French prime minister and parliament.

Chinese regulators are taking steps to curb excessive speculation in markets. Regulators fear that highly volatile conditions in single companies stock due to questionable trading activities could be one reason why large institutional investors are skeptical to invest in the market. Regulators are cracking down on corruption and short-term speculators and both the Shanghai and Shenzen Composite indices have fallen significantly since the start of April. That suggests that regulators are willing to sacrifice short term benefits and retail investors in the name of structural reforms to market dynamics. With the communist party turning over its leadership later this year according to the five year cycle, officials are increasingly focused on stability and reforms. One way they have been reducing such speculation is by raising short term interest rates. Critics of such policies argue that it hurts retail investors and reduces a key source of liquidity since in China retail is a huge provider of liquidity in markets.

As interest rates have rallied in recent weeks investors have been less interested in leveraged loans and other floating rate fixed income products. After the election weekly inflows into US bank loan funds totaled at least $500mm each week between the election and now. In one week is was as high as nearly $2.5bn. However for the first time since the election last week investors put less than $100mm into leveraged loan funds as investors reconsider the global reflation story and they are dissatisfied with high valuations. Investors like those loans in floating rate environments because they change with LIBOR. Falling interest rates has reduced demand for bank loans. as a result many lenders including Serta Simmons, ServiceMaster, Crestwood Holdings, United Airlines, and Las Vegas Sands have all had to either not issue or adjust some of their planned issuances. Additionally from the investor perspective high valuations have reduced the attractiveness of investing in those loans. The yield on the S&P500 leveraged loan index is just 13bp higher than the all time record low and deals have been pricing as low as LIBOR + 200. At that point investors may find more attractive alternatives to park their money in.

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Friday April 21

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