EUROPE DECIDES MAR Elections 2017: Legg Mason Thought Leadership

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1 Legg Mason Thought Leadership Elections 217: EUROPE DECIDES Andrew J. Belshaw Head of Investment Management, London After the political tsunami of 216, the political nexus in 217 shifts to the Eurozone. The Eurozone is focused on parliamentary and presidential elections in 217 Populist parties to the fore in all countries Financial markets are anxious after Brexit and Trump surprises Risk of populist victories seems low but so seem risk premiums Value opportunities may emerge as volatility rises MAR 217 This document reflects the opinions, views and analysis of Western Asset regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers. IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 ANDREW J. BELSHAW Head of Investment Management, London Europe Decides: Elections, 217 Executive Summary Eurozone focused on parliamentary and presidential elections in 217 Netherlands and France go to polls in first half of the year Populist parties to the fore in both countries Financial markets anxious after Brexit and Trump surprises Risk of populist victories low But, so too are risk premiums Value opportunities may emerge as volatility rises Introduction After the political tsunamis of 216 with the unexpected decisions by the British to leave the EU, and the Americans to elect Donald Trump president the political nexus in 217 shifts to the eurozone. The coming months herald parliamentary and presidential elections in the Netherlands, France and Germany all founding members of what became the EU and all vulnerable to the rising populist tide. The immediate focus is on the Netherlands and France (on which this paper will primarily concentrate), whose electorates make their choices over the next two months, and are seemingly most vulnerable to political rebellion. What is the likelihood of success for the anti-establishment parties? What are the implications of such success politically? And what will it mean for financial markets? Netherlands The Dutch go to the polls to elect the 15 members of its second chamber, the Tweede Kamer, on 15 March, 217, from which a new government will be formed. In common with 16 other eurozone members, the Netherlands operates a proportional representation (PR) electoral system. However, unlike its near neighbours Germany and Belgium, it does not have an onerous minimum threshold by which a political party gains members of parliament. As long as a party gets.67% of the votes cast, it will gain a seat, consequentially, around 1 parties have representation in the Tweede Kamer post an election. As a result, the Dutch system has led to formation of coalition governments for all of its post-wwii history. With the rise of populist and single-issue parties in recent years, the fragmentation of political support will leave, in our opinion, the electoral situation no different if not worse this year with a coalition of up to five parties likely, as opposed to the usual two or three. The current government is headed by Prime Minister Mark Rutte s centre right, People s Party for Freedom and Democracy (VVD), in coalition with the centre left Labour Party (PvdA). The latter has seen a sharp haemorrhaging of support over the last five years, such that it is predicted to lose nearly two-thirds of its Members of Parliament (MPs) on 15 March. The VVD is thus closely tied at the top of the polls with the farright Geert Wilders-led Party for Freedom (PVV) at a projected 25 seats each both well short of the 76 seats necessary to have a parliamentary majority. With the PVV marginally ahead in the polls, are they likely to form a government? In short: No. The other major parties have explicitly ruled out going into coalition with them, such that it is now virtually impossible for the PVV to garner enough support to form a government. The election is being fought around the issues of healthcare and pension reform, which favours the centre left, and single-issue parties, housing and immigration, which is favourable territory for the PVV. The degree of compromise necessary to reach agreement on these issues by potential coalition partners will determine the final make-up of the government. As can be seen from the current opinion polls, the VVD will likely be in a position to form a coalition with the CDA, D66, PvdA and a minor party or two. Indeed, it is difficult to see the PVV being involved in any way unless they get 45 or more seats, making them far and away the largest party and difficult to ignore in any government formation. However, the current state of the polls, which has seen the PVV losing a quarter of its support in recent weeks, suggests there is virtually no prospect of this occurring.

3 Exhibit 1 Netherlands Political Opinion: 1 Poll Moving Average Projected Seats VVD PvdA PVV SP CDA D66 CU GL SGP PvdD 5+ Other Feb 15 May 15 Aug 15 Nov 15 Feb 16 May 16 Aug 16 Nov 16 Feb 17 Source: Peil, De Stemming, Ipsos, I & O Research, TNS NIPO. As of February 28, 217 A VVD-led government is thus the most plausible outcome a continuation of the current situation and thus unlikely to result in any disruption in European asset markets. Dutch government bond spreads are still at the tighter end of recent trading ranges, and in our opinion, offer little value at current levels. While obviously vulnerable to any PVV-inspired political surprise, given the likely result, a modest widening is likely to occur if we see some rolling back of recent pension reforms as a price of coalition agreement with the attendant negative fiscal consequences. We would look to invest at spreads of 3 basis points (bps) or more relative to German bonds. Exhibit 2 1-Year Yields: Netherlands/Germany.7.6 Spread Spread in Percentage Points StD Average 1 StD Apr 1 Oct 1 Apr 11 Oct 11 Apr 12 Oct 12 Apr 13 Oct 13 Apr 14 Oct 14 Apr 15 Oct 15 Apr 16 Oct 16 Source: Bloomberg, Western Asset. As of February 1, 217 France The presidential election is a two-round process, designed as such to prevent extreme candidates from capturing the presidency. The two candidates with the largest number of votes from the first round on 23 April will face off in the second-round vote on 7 May. Currently, there are 1 declared candidates, five of them realistic candidates. The left wing is represented by Jean-Luc Melenchon (La France Insoumise) and Benoit Hamon (Socialist Party), with centre right and far right by Francois Fillon (Republicans) and Marine Le Pen (Front National), respectively. Former socialist and new party founder Emmanuel Macron (En Marche) bestrides the centre. Western Asset 2 March 217

4 The candidates currently commanding around 2% or more in the opinion polls are Macron, Fillon and Le Pen with Melenchon and Hamon commanding between 1% and 15% each. The winner of the contest is likely to emerge from the former three. However, if Melanchon and Hamon come to an electoral arrangement, with the latter the likely front man, such that the far left are unified the probability is that the far left moves up to 25% in the polls, blowing the race wide open. Exhibit 3 Presidential Opinion Polls: First Round Le Pen Fillon Percent 15 1 Macron Melenchon Hamon Jan Jan Feb Feb Feb Feb Jan-1 Feb Feb Feb Feb Feb 17 Source: Ifop-Fiducial, Elabe, OpinionWay, Kantar Sofres, Odoxa, BVA. As of February 16, 217 Le Pen has been static in the polls over the last few months at 25%. This has historically been enough to ensure passage to the second round. Both the markets and commentators believe that she will definitely be in the second round. Who she will face, however, is up for grabs. After the emphatic victory by Fillon in the Republicans primary in November, it looked as though he was assured of contention in the second round. Since the emergence of corruption allegations, particularly in the payment of public funds for allegedly questionable employment of his wife and children, his support has eroded substantially. With Macron then declaring and entering the race, the centrist vote has had an alternative which has boosted his ratings. At present, the likely run-off contender against Le Pen will emerge from these two. However, Fillon being forced to withdraw from the race cannot be ruled out. After Alain Juppe ruled himself out of replacing Fillon for the Republicans, a new candidate may emerge to upset the electoral arithmetic. However, the deadline for this to happen is 17 March, thus the room for manoeuvre is limited. Assuming Fillon remains in the race, as is his declared intention, based on current polls either Macron or Fillon should comfortably defeat Le Pen in a second round run-off although the recent scandals to engulf Fillon has seen his potential margin of victory narrow to 14%. Even with the electoral surprises of last June and November, it is difficult to imagine the leads shown here will be eliminated by shy Le Pen voters. However, it is not inconceivable that things could change if an exogenous event, such as another terrorist attack, occurs near polling day. A more plausible route to a Le Pen victory would be if, as mentioned previously, the far left unite under a single candidate (Hamon), taking his vote towards the 25% level, squeezing out the two centrists. In such an environment it is hard to call which way the centre vote would fall. A victory for Hamon/Melanchon or Le Pen in a second-round runoff would, in our opinion, eventually be detrimental to French assets. If it is Macron or Fillon in the second round against Le Pen, we expect whichever of the former two qualifiers will win. This, on the other hand in our view, would be a positive for French assets given the underperformance they have suffered over the last three months and we would envisage French bonds to tighten relative to their Western Asset 3 March 217

5 Exhibit 4 Presidential Opinion Polls: Second Round 8% 7% 6% 5% 4% 3% 2% Fillon Le Pen Fillon Lead 7% 6% 5% 4% 3% 2% Macron Le Pen Macron Lead 1% 1% % Sep Apr 216 May Jun 216 Dec Jan Feb 217 Source: Ifop-Fiducial, Elabe, OpinionWay, Kantar Sofres, Odoxa, BVA. As of February 16, Feb 217 % Jan Apr 216 Nov 217 Jan Feb Feb 217 German counterparts. A Fillon victory would be a more long-term positive given his pro-business agenda which, if implemented, should begin to address the long-term structural and competitiveness problems that France has. Macron would be less economically positive given his more centrist agenda. If the Far Left unites behind a single, unity candidate and squeezes out both Macron and Fillon in the first round, the outcome is clearly very negative for French assets as the likelihood of a Le Pen victory rises substantially. If Hamon/Melanchon win, some relief rally may occur given their pro-european stance, however, their economic program would only worsen the problems France faces meaning that any retracement in French bond spreads to early 216 levels is unlikely. A Le Pen victory would be unequivocally negative as it would combine an anti-eu program with an antireform domestic economic program. French bond spreads should widen sharply. However, it must be borne in mind that it is highly questionable how much of the Front National program would be enacted. While the President has wide-ranging powers, they are limited by the Prime Minister and Parliament, particularly in the House of Representatives. Le Pen s party has only a small representation in the latter and even with elections to the chamber following closely on the Presidential election, the electoral system is such that it will be very difficult for the Front National to meaningfully increase their numbers, let alone be in a position to appoint Exhibit 5 France: Government Bond Spreads Spread (%) Spread to Germany Source: Bloomberg, Western Asset. As of February 17, 217 Western Asset 4 March 217

6 one of its members Prime Minister. This is crucial, as under the French Constitution only the Prime Minister or either of the chambers of Parliament can initiate a referendum (on the EU). With political deadlock, French asset (and indeed all peripheral European) spreads are likely to widen due to the uncertainty, but it will take markets quite some time to fully price in a break-up of the euro. We have had a negative view of French assets for a number of years because of the structural challenges to the French economy and the lack of desire to confront them. We have favoured German and Belgian bonds instead. Post the election of Donald Trump in the US, we thought French risk premiums could rise further, believing the election uncertainty in an increasingly populist world was not priced in. We will continue to maintain this position until we believe spreads more adequately compensate us for the risks entailed. Depending on the evolution of opinion polls and the first round of the presidential election, that would be somewhere north of 1 basis points against Germany on a spread basis. Investment Risks The opinions and views expressed herein are subject to change and are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Yields represent past performance and there is no guarantee they will continue to be paid. Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Outperformance does not imply positive results. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Active Management does not ensure gains or protect against market declines. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. Definitions The European Union (EU) is an economic and political union established in 1993 after the ratification of the Maastricht Treaty by members of the European Community and since expanded to include numerous Central and Eastern European nations. The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities. The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency. A basis point (bps) is one one-hundredth of one percent (1/1% or.1%). A spread is the difference in yield between two different types of fixed income securities. A credit rating is a measure of an issuer s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor s, Moody s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Investment Grade securities are the highest rated securities, while Non-Investment Grade, known as High Yield, are the lowest rated. Please see or for details. Nominal yield is the amount of income earned from a fixed-income security divided by the security's par value, expressed as a percentage. Real yields in this example are calculated by adjusting stated nominal yields by the annual percentage change in CPI (or Core CPI) for each month shown. Yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Western Asset 5 March 217

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