The shock decision by President Macron to call a new legislative election in the wake of the European elections has seen increased focus and trading activity in French government bonds, the CAC40, French banks, and to a lesser extent selling in the EUR.
What Macron called a “moment of clarification” is causing a real moment of intense focus for investors who have now to evaluate the implications of this election and the medium-term outlook for the public finances of the Fifth Republic. Both political blocs have been promising more debt-funded spending programmes, fuelling a record deficit that is driving a dangerous dynamic in France’s debt-to-GDP ratios and moving it closer to Italy’s before the eurozone crisis.
“Traders are attempting to price certainty around the potential political outcomes and with such poor visibility, we have seen some exacerbated moves,” said Chris Weston, Head of Research at Pepperstone. “It is a complicated theme to manage, as it requires an understanding of French politics and the relationships between the political parties. Fundamentally, it requires an understanding of government fiscal targets and its desire to adhere to them, as well as impact and the connection to the capital markets.”
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Unsurprisingly, financial markets in France panicked in the days following the European elections. French equities lost almost 7% in the week after and government bond yields spiked to almost 3.4% at one point. French 10-year government bond spreads over German bunds rose almost 30bps last week, higher than the Meloni move in Italy in 2022 but still much lower than the ~130bps widening seen in UK gilts in September 2022.
“We do not currently believe that this is the “Truss moment” for France but rather a short-lived market correction somewhat comparable to the slight spread widening of Italian government bonds around the Italian elections in 2022,” said Marco Pabst, Chief Investment Officer at Arbion. “However, the elephant in the room for France and Europe remains the French deficit and rising debt-to-GDP.”
Fiscal slippage is the big worry
The big concern centres around the future fiscal slippage and the fallout if a change in government leads to increased spending that pushes out the government budget deficit and increases the debt/GDP ratio. France’s ongoing relationship with the rest of Europe would also be called into question, should a new government look to increase deficit spending by adopting a significant pro-growth strategy.
France already runs a budget deficit of 5.5% of GDP, well above the 3% limit imposed by the EU’s fiscal rules, with public debt of 112% of GDP, exceeding the EU’s limit of 60%. This has resulted in France being placed on the EU’s Excessive Deficit Procedure (EDP) list, which kicks in next year, with the Macron government agreeing to €20bn of annual spending cuts each year until 2028 to get to the EU targets.
With Marine Le Pen’s Rassemblement National party (RN) securing a sizeable 31.4% of the votes in the recent European elections, the three recent polls we’ve seen have since cemented the RN party’s prospects. These polls suggest the RN party could obtain between 235-265 seats, just shy of the 289 seats needed for an outright majority. It has certainly put RN in a strong position and European markets are pricing the clear prospect of a relative majority.
Markets braced for two rounds of voting
There are two rounds of votes that will decide who governs the French parliament. The first will be held on 30 June and involves all candidates. An outright winner will be declared if one candidate can achieve 50% of the votes. If there is no outright majority, then the two candidates with the highest number of votes will go through the second-round vote, to be held on 7 July. This setting can be very tactical, where the candidates still in the race will look to forge alliances or endorsements from those who have dropped out to enhance their prospects.
The candidate with the highest number of votes will be declared Prime Minister, while Macron will remain as President unless he decides to resign – a fate he’s twice denied, but a weak showing in the first round vote on 30 June could suggest he’ll alter that thinking.
“The real concern unfolding is an outright election victory for the RN party and a move away from the EU’s fiscal rules,” said Weston at Pepperstone.
“We have seen implied volatility in EUR options pricing rising, so traders are expecting increased movement in EUR assets, and that will only likely increase as we head into the first round vote on 30 June. However, whilst it is not a done deal that Le Pen’s RN party will govern, if the polls are on the money, then the prospect that the French-German yields differential rises above 80bp looks possible – a factor which would only promote further downside risk in the CAC40, banks and the EUR.”
