Sunday’s French elections have averted the worst-case scenario of a far-right victory but have plunged the country into a period of political uncertainty and potential paralysis. Analysts on Monday advised investors to remain vigilant, prepared for volatility, and attentive to the evolving political landscape.
“France went from favouring the far-right to giving support to the far left in just a week’s time,” said Ipek Ozkardeskaya, senior analyst at Swissquote Bank, in a comment. ”The French are looking for solutions in two extremes and that’s not an ideal outcome.”
France faces particular scrutiny in financial markets given that it is one of five EU member states with a government-debt-to-GDP ratio above 100 percent. At 110.6 percent, its debt-to-gdp ratio trails only that of Greece (161.9 percent) and Italy (137.3 percent), and just ahead of Spain (107.7 percent) and Belgium (105.2 percent).
Financial markets were expected to remain cautious as they digested the implications of the new political reality. In mid-afternoon trading on Monday, the CAC40 index traded marginally higher. Bond markets were uncertain, with the gap between Germany and France’s 10-year bond yields widening to 71.1 basis points before narrowing to 66 basis points.
‘Deadlock’ as most likely scenario
Frederic Leroux from Carmignac highlighted the unexpected scale of the far-right’s defeat and the resulting political deadlock. “The most likely scenario is that of a deadlock preventing any major legislative initiative,” he said in a note to investors. “France will then manage its day-to-day affairs, until the next dissolution (in over a year’s time) or the resignation of the President of the Republic, against a backdrop of further deterioration in public accounts.”
The leftist coalition, the New Popular Front, emerged with the most seats, leaving Emmanuel Macron’s centrists in second place and Marine Le Pen’s far-right National Rally in third. With no single party or coalition able to form a majority, the French Assembly is left fragmented. Prime Minister Gabriel Attal’s offer to resign adds another layer of uncertainty, as President Emmanuel Macron contemplated his next steps in government formation.
Coalition options are limited
Period of instability looming
Frederik Ducrozet at Pictet Asset Management noted that, since the establishment of the Fifth Republic in 1958, the French parliament has never been as fragmented as it is now, with no party coming close to a majority. “A coalition government is arithmetically possible, but politically difficult to achieve,” he said. “A period of instability is likely before an agreement can be reached. Meanwhile the deteriorating fiscal situation will be the most pressing challenge facing the next government.”
Higher risk premium justified, says Pictet
Financial markets have priced out the tail risk of more extreme scenarios, but protracted political and fiscal uncertainty justifies a higher risk premium attached to French assets. “We expect the 10-year French OAT spread over Bunds to hover in a range between 60 bps and 80 bps in the months ahead, and the euro to trade in the 1.05-1.07 range against the USD in H2,” Ducrozet told investors.
60% of French bonds is foreign owned
Guillermo Felices of PGIM Fixed Income suggested that while volatility is expected, there are opportunities to buy on dips, given the high foreign ownership of French government bonds. “French government bonds are 60 percent owned by foreign investors, so a bit of volatility in the coming period would not surprise us. The roadmap should be to buy on dips. The next hurdle is negotiations on how to bring down the budget deficit.”
On the equity markets, despite less than 20 percent of CAC40 profits being generated in France, it’s possible that asset allocations to France will be permanently reduced, Leroux said. Now that the market’s apparent ‘worst-case scenario’ has been averted, he said that “superior exporting companies” should once again outperform the French equity market, ”which is going to be affected by a clear and lasting lack of domestic dynamism”.
French-German spread seen widening
Analysts, including Leroux, foresee a divergence between French sovereign credit and that of Germany. The spread, currently between 70 and 75 basis points, is likely to widen, they said. increasing the cost of French debt and exerting pressure on the French economy.
“Overall, we are still constructive on fixed income, but guard against the potential for volatility, thinner summer markets and tight spreads,” added PGIM’s Felices.
Macron no longer in driving seat
At Berenberg Bank, chief economist Holger Schmieding pointed out that French president Emmanuel Macron now no longer is in the driving seat in determining the next government and will be “forced to accept whatever a potential cross-party arrangement in parliament suggests”.
“In the long term, partial reform reversals and a less favourable reputation among global investors will likely reduce trend growth and raise inflation in France,” Schmieding told investors. ”Coupled with potential credit rating downgrades, this would raise financing costs and exacerbate France’s credit woes over time.”
For Europe as a whole, Schmieding said, the fact that French voters have rejected a far-right government comes as a relief. Although France will struggle to comply with EU fiscal rules, it will likely be more cooperative than it would have been had there been a government under Le Pen’s National Rally.