Navigating Rates

France election: update

Amid a hung parliament, should investors hang around?

While a hung parliament was expected, the second round of the French election still delivered a shock result: the far-right National Rally was pushed into third place in a result that triggers days if not weeks of negotiations between the parties to form a government.

With the most seats, France’s left-wing New Popular Front (NFP) alliance is in pole position. But the worst-case scenario for markets – an NFP absolute majority – has been averted. Its high-tax and high-spending agenda – which includes a wealth tax and freezing the price of basic food items and energy – was seen as a threat to financial stability.

Therefore, a hung parliament should be a near-term positive for markets because both the far right and leftist parties lack the seats to implement extreme policies.

Overall, market reaction has been muted, with investors in wait-and-see mode. The 10-year France-Germany spread widened slightly on Monday morning to 71bps, before narrowing to 65bps. The formation of a new government could take some time and there is no visibility on alliances. But the lull should be temporary.

Deficit worries

The risk premium on France will continue as the country is on a trajectory of deteriorating public finances and reforms are necessary. The markets will pay close attention.

With the country’s budget deficit standing at 5.5% – and its government debt-to-GDP ratio at 110% – a hung parliament could lead to political stagnation.

It comes at a critical point in France’s relationship with the European Union. Our analysis suggests that the French deficit will fail to reach the EU benchmark of sub-3% within a five-year timeframe.

Therefore, investors will want to monitor how the incoming government – whatever its make-up – will handle its interactions with the EU and the degree of assertiveness it will adopt to implement its electoral commitments.

Going forward, we expect France’s debt-to-GDP ratio to rise further. Just to stabilise this number would require the budget to be cut by around two percentage points of GDP a year relative to the current baseline scenario. Given the election results, implementing austerity measures will be very difficult to achieve.

Implications for OATs

The implication is that OAT spreads will remain structurally wider than before the European elections, representing a headwind for the euro and European equities. Moreover, with President Macron politically weakened, we expect further pressure on the euro.

A high level of foreign ownership makes French government bonds vulnerable.1 Japanese investors, for example, currently have potentially attractive yield opportunities at home, particularly at the long end of the curve, and may be tempted to make a switch.

Finally, we would reiterate what we said earlier about the soundness of French companies and the fact that only 19% of the CAC 40 index is dependent on the French economy. But investors should expect a higher risk premium and market volatility, even if the worst outcome for markets has not materialised.

1 Source: Allianz Global Investors Global Economics & Strategy, IMF (data as of Q4 2023)

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