French risk - 17 June 2024
Just as they were feeling increasingly relaxed about Europe’s outlook, investors have been caught on the hop by the sudden rise of French political risk. Should the National Rally party come to power, it would be a leap into the unknown that would threaten the fiscal and regulatory environment in France, the nature of the French state and the very foundations of Europe.
According to the polls, the National Rally has a good chance of securing power in France on 7 July with an absolute or relative majority. This is not a big surprise. Investors have had time to get used to this new “populist” trend since the early upheavals of 2016–2018: Brexit, Donald Trump, then Italy and Brazil. The common denominators of these movements are attacking free trade, cracking down on immigration, rejecting budgetary orthodoxy and questioning climate policies. Some of these positions have already permeated existing governments’ and institutions’ discourse and actions, as evidenced by the European Commission’s recent introduction of import taxes on Chinese electric vehicles.
However, particular aspects of the situation in France have led markets to quickly integrate both financial and microeconomic risk premiums into the bond and equity markets. On the bond side, several questions have been raised about French borrowing.
In 2023, France’s government deficit was at its highest non-recession level in recent history at 5.5% of GDP. The IMF estimated that, even as a best-case scenario, it would be very difficult to bring this below 5% of GDP by 2026. The National Rally has yet to firm up its economic programme, but it will undoubtedly keep the deficit at a very high level and therefore bring about a further downgrade of the French sovereign credit rating.
However, this downgrading is far from being an insurmountable problem per se. Historically, the level and risk premium of French interest rates have had relatively little correlation with the country’s credit rating (cf. chart 1) because many other more important elements come into play: growth, inflation, global rates etc. France’s rating downgrade from 2012 to 2015 did not prevent a sharp fall in long-term rates and even in the spread with Germany during the same period. Moreover, the rise in French rates since 2021 has reflected global trends rather than country-specific issues. Finally, stress phases on sovereign spreads are often accompanied by a fall in German long-term rates (flight to quality), which tends to limit rate rises in struggling countries. This is what has happened recently: The increase in the France-Germany spread, from 50 to 75 basis points, was due almost entirely to the fall in German long-term rates. At 3.10–3.20%, French long-term rates are clearly not a cause for concern. As for the OAT-Bund spread, it has simply returned to where it was during the 2017 election campaign.
Could this situation, which for now is fairly benign, deteriorate and turn into a real crisis? It is a question worth asking because French debt has quite a different status on a European and global stage to that of Italy. Together with German bonds, OATs are used as a euro-denominated foreign exchange reserve by many nations around the world (Switzerland, Japan, Middle Eastern countries etc.). Moreover, France is perceived as a political, economic and monetary pillar of Europe, which considerably ups the ante. Were France’s outlook to change, it would shake the foundations of Europe to the very core and entail profound economic and financial consequences.
The stakes are therefore high, but some key elements mitigate the risks. First of all, the paradox of the National Rally is that the less aggressively anti-Europe it has become, its chances of coming to power have increased. Frexit has been axed from its manifesto ever since Marine Le Pen’s heavy defeat in the second round of the 2017 presidential election, and the “national priority” notion of France-first occasionally gives way to Europe-first (for example, on access to public procurement). On the other hand, Emmanuel Macron seems determined to cling on to power, which will reassure investors about France’s European commitments. From an institutional standpoint, the ECB will be able to step in whenever it deems market turmoil to be excessive by way of its TPI (Transmission Protection Instrument) stabilisation mechanism.
In our opinion, as long as French long-term rates do not start to spiral upwards, there is no fundamental threat to the favourable macroeconomic scenario that has bolstered European equity markets. However, there is one final component of the risk premium associated with a probable National Rally victory: how certain potential populist measures might impact listed companies. In Italy in 2023, Giorgia Meloni wanted to introduce a one-off windfall tax of 40% on banks to finance her programme, although the tax was watered down soon after. The French stock exchange has begun to factor in risk premiums of this nature in certain sectors considered to be vulnerable (cf. chart 2): banks, of course, but also insurers, motorway companies, energy suppliers, telecom operators etc.
Are these risk premiums sufficient? The 11% tumble for French financial securities is now equal to the one seen in Italy last year when the 40% one-off tax was announced. This is a sign, especially since financials are now very well capitalised and much more profitable than in the 2010s. Given their very low valuation (cf. chart 3), only a major shock would justify further sharp falls. Conversely, a clearer picture would see stocks bounce back strongly.
The turmoil faced by French securities has had a significant impact on European markets. Listed French companies account for 35% of the MSCI EMU market capitalisation (versus 25% for German companies) and almost half of the bond market for non-financial companies. The negative impact of French risk is stronger still because, in recent weeks, investors have had a positive outlook on European equities, which they are now being led to reconsider. As things stand, we are not changing our core scenario of European economic recovery and disinflation. In our European and global allocation funds, we hedged our positions in the European financials baskets on Monday, 10 June 2024 with eurozone bank futures. We will adjust these hedges or down according to our assessment of the risks and opportunities brought about by the French elections.
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