The ghosts of political risk visit Europe again

The ghosts of political risk visit Europe again | Financial markets

It has been a long time since political risk made an appearance in European financial markets. The times when investors punished the euro zone for doubts about the sustainability of sovereign debt – specifically that of peripheral countries – or directly about the viability of the European project are long gone. This week, however, the selling pressure has returned to the scene and this time its epicenter is not in any peripheral country but in one of the founding partners of the EU and historical promoter of European integration: France. The French Cac has suffered its biggest weekly drop in two years and the French risk premium has climbed to 2017 highs, infecting the euro zone as a whole with the wave of sales in its financial market.

The result of the European Parliament elections last Sunday has confirmed a generalized advance of the extreme right in Europe that has not managed to break the current majority of conservatives, social democrats and liberals but has caused a political earthquake in France. Marine Le Pen’s National Rally has swept the country and precipitated the calling of legislative elections by Emmanuel Macron for next June 30 in the first round and July 6 in the second. A risky move by the President of the Republic with which to test Le Pen’s true strength on a national level and which has put investors on alert.

The downgrade of France’s sovereign rating decided by Standard & Poor’s on May 31 passed without pain or glory through the financial markets. It was not until this week, in the midst of the hangover from the European elections and the call for legislative elections in the country, that investors have focused on the situation of the French public accounts and the possibility of a change of government in France. represents a paralysis, if not a setback, in the European project.

In just a few days, the French risk premium has shot up above 75 basis points, to the highest level since 2017, just the year in which France held an election that came close to giving the presidency to Marine Le Pen, defeated finally in the second round by Macron. The spread of the French one-decade bond against the Spanish one has been reduced to the lowest level since 2009, to just 15 basis points, and has become almost non-existent compared to the Portuguese bond, an unusual fact in the financial market that reflects the distrust and investor nervousness regarding the new political scenario in France. The selling wave has also reached the Stock Market and has spread beyond the French stock market, although the Cac is the worst index of the week, with a decline of more than 6%. The punishment has been especially harsh with the bank. As in other episodes from a past that seemed very distant, French sovereign risk has ended up infecting the entire euro zone. Spanish and Italian banks have fallen sharply on the stock market, while risk premiums in both countries have risen by more than 20 basis points in the last week.

But why is a possible victory for Marine Le Pen so worrying both domestically and in Europe? On the one hand, investors are already sending a clear message of what they ask of the new French cabinet: a clear commitment to fiscal consolidation for a country that has moved away from Brussels’ deficit and public debt objectives just as next year compliance with fiscal rules will resume. Fiscal indiscipline is harshly punished in the market, as was already seen during the brief mandate of the British Liz Truss in October 2022 with her drastic tax cut proposal, and investors are on guard against a political formation that proposes reductions of taxes and that does not have government experience at the state level. The current French finance minister, Bruno le Maire, did not hesitate this week to compare the market impact of a Le Pen victory with what happened in the United Kingdom. “If the National Group implements its program, a debt crisis in the style of what happened with Liz Truss is possible,” he said on Tuesday.

On the other hand, National Rally is a eurosceptic party. He has renounced the groundbreaking speech of the past in which he proposed the abandonment of the single currency – “the euro is dead”, proclaimed Marine Le Pen in 2017 – but he is hardly going to champion pending challenges for the euro zone such as the enormous financing necessary to improve productivity or the single capital market.

“The euro zone is at a crossroads, it must decide how to face its decline against the United States and China. Europe currently exports its savings towards investments in the United States. And Le Pen is not going to question the euro, but she could stop any strategic initiative that requires more integration,” explains Raymond Torres, director of Economic Situation at Funcas. Furthermore, according to Torres, “France is probably the country in the euro zone with the worst fiscal outlook.” An element that explains the nervousness of some investors regarding a possible government that proposes tax cuts.

The French economy closed 2023 with a public deficit of 5.5% of GDP, above the 4.9% expected for that year, and a debt-to-GDP ratio of 110.6%. And in April, the government revised upwards its fiscal imbalance forecasts for this year: it now expects the deficit to reach 5.1% of GDP, instead of the 4.4% of the initial objective, to be reduced to 4.1% in 2025 and to 2.9% in 2027, the last year of Macron’s mandate. Rating agency Moody’s, which maintains France’s Aa2 rating, warns that “the country’s debt burden is the highest among its similarly rated peers, and large structural budget deficits have led to a nearly continuing debt burden since the 1970s. Moody’s even foresees an increase in the debt-to-GDP ratio from 110.6% in 2023 to 115% in 2027.

The impact on the market

Richard Brown, client portfolio manager at Janus Henderson, acknowledges that the European election result and its effect on French politics have reminded investors of political risks that had been relegated to the background in the past. And from Credit Agricole they recognize that, although the rhetoric of exiting the euro is no longer in Le Pen’s speech, in the event of an electoral victory for the National Group “the perception of foreign investors will be strongly affected, seeing a government that lacks experience leading the country.” Especially if it achieves an absolute majority.

The most recent fear is that a second round would pit Le Pen’s party not against Macron’s but against the grouping of leftist parties, whose eventual victory would not be the market’s favorite bet either. The coalition of left-wing parties, which brings together the social democrats and the Jean-Luc Mélenchon’s Eurosceptic populists presented his economic program this Friday, which includes reversing Macron’s pension reform, recovering the option to retire at age 60, an increase in the minimum wage and an extraordinary tax on corporate profits. The announcement of his proposal accelerated the stock market fall on Friday and the rise in risk premiums.

Goldman Sachs has calculated that the full implementation of the National Rally electoral program would mean an increase in the yield of the French bond to a decade of 50 basis points. Its advance in the last week has reached 13 basis points, despite the fact that the risk premium with Germany has shot up by almost 20 basis points, to around 75. The US bank does not foresee in any case that Le Pen develop your program to the fullest. This eventual new government was going to encounter the practical difficulties of exercising power, with the pressure and close surveillance of the market and with possible electoral calculations for the presidential elections of 2027. Goldman Sachs in fact estimates that the French debt differential remains contained after the recent rise although this does not mean that the French bond is at an attractive entry point. Especially if it is compared to the Spanish bond, unrelated to the effects of a domestic policy that is also turbulent. At UBS, however, they do consider that an increase in the French risk premium above 55 basis points is an opportunity to tactically purchase the 10-year French bond. In any case, and once over 70, he also points out that it is time to “wait and see” what the electoral alliances and possible fiscal policies are.

Goldman Sachs also points out that French sovereign debt will not be subjected to the tension of 2017, when the French risk premium touched 80 basis points, despite now exceeding 75. “The reason is that the presidency of the Republic does not is at stake and that the National Group is not explicitly encouraging exit from the EU or the euro,” explains the entity. The US bank even assures that the political response given by the euro zone to the most recent crises – the ECB’s anti-fragmentation TPI mechanism in the euro zone and the Next Generation program – “has set the bar increasingly higher for internal factors or idiosyncratic impact on differentials. This suggests to us that, overall, the current rate environment is a more favorable starting point for sovereign credit than that which prevailed in the years following the Great Financial Crisis, when euro area risk was more present. .

Despite the calls for calm and the differences with episodes of the past, the response of investors reminds that the risks are there. “A eurosceptic government in a country as big as France increases the risk of fragmentation in the euro zone,” says José Manuel Amor, an AFI expert. And in extreme cases, the activation of the risk premium containment program (TPI) designed by the ECB in June 2022, in the run-up to interest rate increases, is not unrelated to compliance with fiscal discipline, a pending challenge for France. The ECB’s support would not be free and would therefore go hand in hand with the adoption of measures by the struggling country to reduce its debt. “The market is going to remain nervous until the second round of the elections in France,” adds Amor. The mood of investors after July 6 will depend on the result.

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