The spread on French government bonds has peaked again, showing that financial markets are on edge ahead of Sunday’s elections. Until they conclude later in July, many investors are favouring other European government bonds, like Austria, Finland and Ireland. «Any reminder of the European debt crisis is a red flag for international investors,» one analyst remarked.
The gravity of France’s situation is becoming increasingly apparent. President Emmanuel Macron has called for elections following a significant victory by the far-right in the European elections, signalling widespread discontent with current policies.
Bond investors are wary that an extremist government might implement even more problematic fiscal policies than those that Eurozone’s second-largest economy is used to. Currently, investors are demanding a 3.1 percent yield on French 10-year government bonds, which is 72 basis points higher than the yield on equivalent German bonds.
The forthcoming election is not only contributing to short-term market volatility but also casts doubt on any long-term fiscal solutions from the Élysée Palace. As a result, many investors are steering clear of additional French debt despite the steep discounts available.
French debt in focus
Investor concerns are justified. France ranks as the third-largest sovereign debtor globally, trailing only the United States and Japan, yet its economic growth remains sluggish. With public debt at 112 percent of GDP, compared to the Eurozone average of 90 percent, and Germany’s 63 percent, the financial burden is significant. Additionally, France’s budget deficit stands at 5.5 percent, exceeding the Stability and Growth Pact’s legal limit by over 2.5 percentage points.
The financial implications are profound. If France were to pay 3 percent interest on its total debt of approximately €3,100 billion, the annual interest cost would approach €100 billion. This figure represents 7 percent of total government spending, outstripping defense expenditures by one and a half times.
Earlier this month, S&P downgraded French government bonds from AA to AA-. Concurrently, the European Commission has suggested placing France under the excessive deficit procedure for eurozone countries whose debt no longer meets the common criteria.
Election uncertainty
Polls indicate that the right-wing bloc led by Marine Le Pen commands 33 percent of the vote, while the left garners 28 percent, and President Macron’s party hovers around 20 percent. This suggests the right-wing bloc could achieve an absolute majority, although a minority government is more likely.
In such a scenario, the president and prime minister would hail from opposing parties, complicating major decisions like tax reforms. Investors fear this could lead to unchecked national debt growth, half of which is held by foreign entities.
Gerard Moerman, head of fixed income at Aegon AM, is wary of increasing his positions in French government bonds due to these uncertainties, despite their attractive discounts. «In the short term, the elections could still trigger volatility and selling. Hence, we prefer semi-core European countries like Austria and Finland,» he told Investment Officer. Bonds from Portugal and Spain are also considered better investments than French sovereign debt, which he believes will continue to rise.
Rob Dekker, senior fixed-income portfolio manager at Achmea AM, acknowledges that the market may be overreacting, with risks already priced in. However, he too feels more secure with government bonds from other European countries, such as Ireland and Austria. «Ireland and France were trading at an equal spread not long ago, but Ireland’s fiscal situation is much more favorable,» he noted.
Short-term bonds and alternatives
Richard Abma, chief investment officer at OHV, sees value in short-term French government bonds, which currently offer a 3.75 percent yield. «The risk of sharp interest rate hikes is limited, making short-term French debt quite attractive,» he stated.
For investors wary of a euro crisis, US dollar-denominated bonds provide an alternative, offering a 4.2 percent yield. Allianz, among others, recommends an overweight position in the dollar against the euro. «Despite recent positive surprises from Eurozone data compared to a weaker US outlook, any hint of a European debt crisis alarms international investors,» noted Gregor Hirt, global chief investment officer at Allianz.
Although a euro crisis appears distant, the European Central Bank’s Transmission Protection Instrument (TPI) can intervene in bond markets if interest rates rise too rapidly, offering some reassurance to jittery investors.
This article originally appeared in Dutch on InvestmentOfficer.nl.