Yesterday, we presented a Deutsche Bank research report which tried to evaluate whether, despite polls suggesting otherwise, a Le Pen-Melenchon first round victory was possible in the French election this coming Sunday. In a surprising break from the conventional wisdom, this is what DB concluded:

Melenchon’s rise in the polls has been one of the key market drivers since the end of March. Further decline in Hamon’s votes is unlikely to support Melenchon to the same extent as it did in the last three weeks. However, the more important point is that the risk around the first round persists as (a) the top 4 candidates are within the historical margin of error and (b) the high level of undecided voters increases the uncertainty of the outcome.

Why so much attention on Le Pen-Melenchon? Because as the WSJ wrote this morning, "with the start of the French election just days away, investors are contemplating their nightmare scenario: a choice between far-left and far-right candidates. In recent days, a surge in opinion polls has placed Jean-Luc Mélenchon, a left-wing firebrand who promises higher wages and fewer working hours, as a potential candidate to move past this Sunday’s first round of voting. That could set up a second-round vote in May 7 with Marine Le Pen, an economic nationalist who wants to pull France out of the euro."

A runoff between Ms. Le Pen and Mr. Mélenchon “would be a disaster for France…[and] a disaster for Europe,” said Patrick Zweifel, chief economist at Pictet Asset Management. Under that scenario, investors would dump the debt of France and of weaker European economies and send the euro sharply lower, analysts say.

Ok, so we know what the nightmare scenario is, and that as DB explains, it is certainly a probable outcome. What are the other 5 possible permutations for the second round? Here, courtesy of Market News is a breakdown of all 6 scenarios:

Macron-Le Pen (63%/37%, Ipsos poll April 14): The most plausible. The 2 candidates have led the polls for a few months. This scenario would come with no surprise on the financial markets, which have already integrated it.

The most plausible. The 2 candidates have led the polls for a few months. This scenario would come with no surprise on the financial markets, which have already integrated it. Melenchon-Le Pen (60%/40%): The most feared. Risk is not fully priced, so it would come as a bomb on markets. Choose between the devil and the deep blue sea.

The most feared. Risk is not fully priced, so it would come as a bomb on markets. Choose between the devil and the deep blue sea. Macron-Fillon (64%/36%): The most welcome. This would give much appeasement with both Le Pen and Melenchon moved away.

The most welcome. This would give much appeasement with both Le Pen and Melenchon moved away. Melenchon-Fillon (60%/40%): The most surprising. Fillon was not even favoritein the right party primary elections (Juppe was), Melenchon got 11% in 1st Round in 2012 Presidential, but French people know how an outsider can surprise (2002 elections, Le Pen (father) passing in 2nd Round)...

The most surprising. Fillon was not even favoritein the right party primary elections (Juppe was), Melenchon got 11% in 1st Round in 2012 Presidential, but French people know how an outsider can surprise (2002 elections, Le Pen (father) passing in 2nd Round)... Fillon-Le Pen (56%/44%): The most at right. With huge abstention expected from left voters in this scenario, financial markets would not exclude a Le Pen win.

The most at right. With huge abstention expected from left voters in this scenario, financial markets would not exclude a Le Pen win. Macron-Melenchon (55%/45%): The most erratic. It would be feared that Le Pen voters slide towards Melenchon.

That's the summary. For those looking for a more detailed matrix-based breakdown of what to expect, here is BofA's Gilles Moec laying out the nuances of the French "binary event with multiple scenarios"

Next Sunday France will hold the first round of the presidential elections. Out of the 11 candidates, only the two with the highest proportion of the votes will qualify for the decisive second round on May 7. The opinion polls are so tight between the four top contenders that, once taking into account the error margins - as Deutsche Bank has done - they suggest 6 second-round combinations are arithmetically possible, with Le Pen-Melenchon a distinct probability.

BofA continues:

This only should be enough to keep the market on its toes. Indeed, the following scenario analyses indicates that out of these 6 combinations, only one would be “market friendly” (Emmanuel Macron vs François Fillon) in the sense that their stated policies suggest both would strive to keep France in the Euro area and, to varying degrees, would implement reforms to spur potential growth. We also found one scenario “market adverse” (Marine Le Pen vs Jean-Luc Melenchon), with both contenders being eurosceptic to varying degrees and supporting ultra-loose fiscal policy and a re-regulation of

the French economy. The remaining four combinations are binary, opposing one pro-European supply-sider to one Euro-sceptic big spender, see Table 1. We note based on available polls, in three of these cases, the “pro-European” candidate would defeat the “Euro-sceptic” (Macron would win against Le Pen and Melenchon, Fillon would win against Le Pen, although by a smaller margin than Macron). The riskiest of these binary combinations would be Fillon against Melenchon, in our view. Only a few polls tested this hypothesis, but they suggest the radical left candidate would win in this configuration with a comfortable margin.

Finally, here is a detailed breakdown of the supply vs demand economics, and pro-EU vs EU sceptics:

In nutshell, the economic debate around this election is centred on a dichotomy between reform – in particular deregulating the labour market – and protect – in particular affirming the French comprehensive welfare state. The relationship to Europe is to a large extent a by-product of this reform/protection focus. The reformists (Macron/Fillon) insist on the need for France to adapt to the current architecture of the EU, which promotes free competition and sets limits to national fiscal policies. Those who focus on protection consider either that the EU, and in particular the Euro area, is essentially incompatible with maintaining the French welfare state (Le Pen) or needs to be thoroughly reformed to offer space for demand-side fiscal policies and more social rights (Melenchon). Below, we briefly review main stated policies of the main four candidates (starting from the very left going towards the extreme right): Melenchon Melenchon wants to use fiscal policy to bolster the welfare state and growth. This includes a deficit-financed EUR 100bn capex programme and EUR 173bn additional public expenditure over five years. Consequently, the public deficit is expected to balloon to 4.8% in 2018 before gradually declining again, if all goes well (Melenchon explicitly counts on a large multiplier effect). An expansion of social security benefits, and adjustments of public sector pay are intended. Higher tax rates for higher incomes (including an income tax on the revenues of French citizens living and working abroad), revoking past labour market reforms and lowering the statutory pension age to 60 years (from currently 62) are discussed. Nationalisations of previously public companies (energy sector in particular) are among his goals, together with higher regulation and higher taxation for the financial sector. Melenchon is EU sceptic: He has stated that he wants to renegotiate EU Treaties to provide France with more autonomy again, and though not his flagship project, an EU referendum on the renegotiated EU terms is among his considerations. While EMU exit is not explicitly part of his plan (unlike for Marine Le Pen), he is challenging the current functioning of the monetary union. He wants to change the status of the ECB, explicitly allowing the central bank to directly monetise government debt, and lifting the inflation target to 4-5% p.a. In a Melenchon scenario, after an initial sell-off, the market could attempt to stabilise on the belief that Melenchon’s EU goals are sufficiently vague and his parliamentary support sufficiently thin to favour a sort of compromise solution. Although less extreme than Le Pen’s policies, we would still expect that having the second largest economy of the Euro area politically constrained and/or experimenting with ultra-loose fiscal policy would remain a durable drag on any rekindling of animal spirits in the whole region, in our opinion. Macron On fiscal issues, Macron’s policies are more prudent, combining nods to Germany – respecting the 3% limit for the deficit – with a protection of demand: reduction limited to 3% of GDP, public investment programme, no tax hikes and some income boosting measures for low to middle income families (abolition of the payroll tax to fund healthcare, offset by a rise in a wider-base tax , abolition of one local tax for 80% of households). The idea there is to do just enough to procure from Germany some progress on fiscal union (harmonisation of fiscal policy, taxation, unemployment benefits etc are within his considerations as well as a joint Euro area budget and a Euro area minister of economics) and stabilise French debt. On structural reforms, Marron’s motto is "flexibility". Effects on potential growth will be predominantly through increased total factor productivity, ie better relations between employers and labour unions and a facilitated integration of innovation in production procedures. But this means that the overall manifesto is vague on the definition of the measures themselves. Here, Macron seems to be pursuing a social-democratic agenda, in which the state sets guidelines but social partners (employers and unions) deal with details at the national or local level. This would allow Macron to avoid frontal controversies with the unions. He wants the pension system to be unified and to offer more choice to employees, but without reducing the overall generosity of the system. The same holds for the unemployment benefit insurance, which would be more efficient – and force jobseekers to be more active – but the overall replacement income would not fall. Working time would be treated in a similar way; 35 hours per week would remain a reference, but with more capacity at the local level to take deviate from it. The overall agenda is tilted towards the supply-side - with for instance a decline in corporate tax from 33% to 25% over the mandate, but the social-democratic approach on structures has never really been tried in France, where unions are weak (less than 10% unionisation) and traditionally the government intervenes in a detailed manner. This unusual approach provides Macron with a sense of novelty, but also deprives him of strong attention-grabbing, quantified measures for investors. While a Macron scenario suggests to us that French and peripheral assets would probably benefit from the disappearance of the Frexit risks, there could be a cap on where French assets could go until proof of some capacity to deliver is shown. Fillon The Republican candidate (Fillon) was the first to publish a full-blown and consistent supply-side intense reform program including corporate tax cuts, labour cost cuts, abolishment of the 35 hour week financed by a 2ppt VAT hike and non-replacement of public sector employees bound to retire. Public expenditure is planned to decline by EUR 100bn during the mandate. The pension age is set to increase to 65 (from currently 62). His program is the most reform-intense on paper with the potential to 'unlock' potential growth of c 1.5%. But as we argued before, sequencing becomes key for his plan to work: Supply side reforms will likely only work if demand does not falter, making a delayed implementation of the VAT hike, for instance, an important determinant of the potential outcome of his reform programme. Broadly speaking, Fillon is pro-European. His supply-side economics reform approach is not far off what Germany has done in 2002-05, and his focus on lowering the deficit and debt burden would probably facilitate further Franco-German cooperation. However, it is less clear how fast and how much additional integration Fillon is actually envisaging for the EU. His policies are clearer on what he does not want (further EU enlargement, additional free trade agreements), while his plans to negotiate fiscal harmonisation (including a Franco-German initiative on corporate tax) are relatively less emphasised. In a Fillon scenario, in short, while the market would probably react positively to Fillon's clear economic agenda and higher probability of achieving a working majority in parliament, implementation may not be as far-reaching as it seemed a month ago and some lack of visibility on the European project could take the edge off the relief rally on the periphery. Le Pen: Le Pen’s flagship project is the EU/Euro area referendum. She wants to renegotiate EU Treaties with Brussels in the first six month of her election. Her stated goal is to restore national sovereignty, and hold an EU referendum. She previously argued that her staying in power would be conditional on a referendum outcome. Popular initiatives shall become a more widely used tool, in general, conditional on 500K signatures from the electorate. Her far-right stance comes with strict restrictions on immigration (10K limit per year) and more limitations to citizenship access. Her economic goal is very similar to that of the far-left: bolstering the purchasing power of households, through income taxes in the lower tranches, helping SMEs through targeted corporate tax cuts and enforcing a production and purchases ‘home bias’ by levying a social charge on imports. Explicitly part of her programme is the central bank: Banque de France independence from the ECB is a key feature, including direct credit financing of the government deficit (planned to reach 4.5% of GDP in 2018), hence her goal not only to reshape the EU, but also to take France out of the monetary union. In a Le Pen scenario, in short, after an initial sell-off, the market could attempt to stabilise on the belief that Le Pen’s capacity to trigger and win a Frexit referendum. Still, we would still expect that having the second largest economy of the Euro area politically constrained and/or experimenting with ultra-loose fiscal policy would remain a durable drag on any rekindling of animal spirits in the while region, in our opinion.

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Here is the bottom line: if on Sunday night the two candidates left standing are the following, it may be too late to sell.