BARCLAYS: 'Markets may have taken the wrong lessons from Donald Trump and Brexit'

• Barclays thinks markets are overestimating risks from French election, underestimating German and Dutch risk;
• Mispricing stems from lack of understanding of what happened with Trump and Brexit - polls weren't wrong, pundits were;
• Biggest European risk is not major upsets at elections but gains for fringe parties, which could destabalise governments and drive "balkanization" of Europe.

LONDON - Barclays believes traders and finance firms have "thrown the baby out with the bathwater" in the wake of Trump and Brexit, and are now overestimating the populist risk in the French election.

After failing to accurately price in the likelihood of a Donald Trump presidency and Britain voting to leave the EU, markets are now swinging the other way and attaching a far higher likelihood of an upset in looming political events, Barclays argues.

The key risk Barclays thinks traders are overestimating is victory for Marine Le Pen's far-right National Front in the upcoming French elections. Her party made surprising gains in early rounds but Barclays says polling data suggests she is not as big a risk as markets seem to think.

FX strategist Martin Barth and his team at Barclays write in a note sent to clients on Friday: "The French election may be the lowest risk event of the coming year, given that the two-stage French electoral system produces clearer, more definitive winners."

'It wasn't the polls that missed, it was the pundits'

Barth and his team believe the risk pricing problem stems from markets completely discounting polling data in the wake of Brexit and Trump. A widespread opinion developed in after both upsets that the pollsters got both events wrong and were to blame for both being such surprises.

But Barclays writes in Friday's note, titled "Trump l'œil":

"While both the UK's "Leave" vote and Mr. Trump were behind in the averages of available polls going into their respective votes, the victories of neither should have been a shock. The average of the polls was wrong in point estimate, i.e. who would win, but not beyond the margin of error in either case. In both cases, the average of polls showed a very tight race and several individual polls correctly forecast the eventual victors. As political writer Sean Trende wrote of the US election, "it wasn't the polls that missed, it was the pundits," a statement that also was true of markets' pricing of both events."

Barclays blamed bias, rather than data, for the market failure, saying market participants were too convinced in their own minds that the status quo would remain.

As a result, Barth believes traders should look again at polling data - which in the case of France is reassuring. He writes: "Ironically, current polls indicate that the French election may produce the only strong and market-oriented government in the remaining EU, and may also lead to greater accommodation in Brexit negotiations, creating an upside risk for both EUR and GBP."

'Underestimating the "Balkanization" risks'

While markets are overestimating the risk of France, Barclays warns that they are underestimating risks associated with Dutch and German elections later in the year. That's because traders and other market participants have become too fixated on headline-grabbing "upsets" and are failing to consider the more subtle risks posed by fringe parties gaining ground at elections, rather than winning power outright.

Barth and his team write: "Markets likely are underestimating the "Balkanization" risks associated with both the Dutch and German elections: a diffusion of political power that results in weak coalition or minority governments (and perhaps an anti-EU one in the Dutch case)."

Fringe parties gaining ground pose a risk by hobbling the ability of governments to work effectively in countries that typically have coalition governments, such as Germany and the Netherlands. This "impairs the ability of the European Council to respond decisively to EU political crises as it did in 2011-12" and could further undermine confidence in the 27-nation bloc.

Advances for populist parties also pose a risk due to their ability to influence the debate on either the left or right. UKIP is a prime example and Barclays bank says that the party "arguably caused Brexit as the UK's Conservative Party was forced to hold a referendum on EU membership due to the indirect electoral threat from UKIP."

Here are some of the political flash points to look out for in 2017:

• March 15, 2017: Parliamentary elections in the Netherlands, where the nationalist, right-wing Party for Freedom is gaining ground;
• April-June 2017: French presidential and parliamentary election, which could see big gains for Marine Le Pen and her right-wing, anti-immigration party National Front;
• September 2017: German parliamentary elections.

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