French President Emmanuel Macron has taken a serious gamble in calling early parliamentary elections. The consequences of putting politics above economic stability could be profound. Financial markets don’t like unnecessary or unexpected political volatility, especially at the core of the European Union. The electorate only gets to vote at elections; financial markets get to vote every day, and so far they’re giving a thumbs down to Macron’s ploy.
Foreign bond investors used to favour a "bund plus" strategy, owning French and German government debt with the pair forming the bedrock of the EU, but with the former offering a modest yield premium. Monday’s jump in the gap to the highest this year shows portfolio managers are concerned about the fiscal direction Paris is headed in.
French debt spreads to those of its EU peers have been remarkably resilient in recent months, despite an evidently worsening political backdrop. Most surprising has been the fixed-income market’s tolerance of a deteriorating annual budget-deficit ratio, which rose to 5.5% of gross domestic product last year. The principal motivation for twin downgrades of the nation's credit rating to AA minus — first by Fitch Ratings on Oct 20, followed by S&P Global Ratings on May 31 — was the inability of a Macron-led administration to enact sufficient fiscal reforms to arrest a deteriorating debt profile. S&P sees France's budget deficit still being in excess of 3% by 2027 and its overall debt still rising.
The European Commission forecasts only a miniscule improvement to 5.3% for 2024. UBS AG Group analysts reckon it’s highly likely that the Commission recommends that France is placed in a so-called Excessive Deficit Procedure as early as this month. If approved by the EU Council, this would require France to reduce its deficit by at least 0.5 percentage points annually, and for its overall debt to be on a clearly reducing slope. The new government would be obliged to present a multi-year fiscal structural plan by late September. That’s not going to sit well with investors.
Throw into the mix the strong likelihood of a "cohabitation" between President Macron and a far right prime minister from Marine Le Pen's National Rally party, and what investors had viewed as a 2027 problem suddenly comes alive right now. “Investors don’t share Macron’s risk appetite,” said Stefan Koopman, senior macro strategist at Rabobank. “His courage is undeniable, we’d give him that, but it seems like doubling down on a bet after a poor performance.” The log pile was already stacked, but now a match has been thrown on. The euro weakened by around 0.5% to the dollar on Monday, with the French stock market underperforming its euro peers.
Still, there’s no sudden funding issue. The French Treasury is just over half way in meeting its 2024 debt issuance target of €314 billion ($340 billion). Investor demand has been healthy so far, with the three syndicated deals attracting investor demand for more than 10 times what was on offer. Nonetheless, a repeat of the 2017 bond market wobble seen in the lead-up to Macron’s first presidential term win isn’t unthinkable.
Tolerance has its limits, and the harsh experiences of the euro crisis more than a decade ago illustrated how toxic political uncertainty can be. A National Rally prime minister could cause serious ructions; while the party has dropped its demands for France to quit the EU, memories are as long as forgiveness is short.
One rationale for Macron's boldness is that it will force Le Pen to reveal her plans for the economy, which up to now have been deliberately vague. A platform that calls for lower immigration is almost certain to be fiscally negative — especially if Macron’s March 2023 decree lifting the retirement age to 64 from 62 gets reversed.
Until and unless some form of political clarity emerges after the July 7 second-round results, there are probably too many uncertainties for risk-averse investors to want to hang around in French securities. Macron may see political advantages in calling a surprise election — but he’s playing fast and loose with investor confidence.
Credit: Bloomberg
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