- Date:
- Author:
- GianLuigi Mandruzzato
The recent burst of inflation in the US and in many other countries has led investors to wonder whether the entire inflation environment has changed.
French President Macron’s decision to call snap elections has sent European asset prices tumbling. In this Macro Flash Note, senior economist GianLuigi Mandruzzato looks at what is worrying markets.
In the wake of the European Parliament vote, French President Macron dissolved the National Assembly (NA) and called snap elections.1 The first round of voting will take place on 30 June and the second on 7 July.2
According to the latest projections, Marine Le Pen’s far-right, eurosceptic Rassemblement National (RN) is the favourite to win a majority.3 The most likely alternative is the New Popular Front (NPF), a new alliance of left-wing, far-left, and green parties.4 According to the projections, the centre-left Renaissance party, led by President Macron, and the centre-right parties, led by Les Républicains, will obtain at most a few dozen seats. The risk of a hung parliament cannot be ruled out.
Financial markets have reacted negatively to the European Parliament vote and to the prospect of an imminent change of government in France. Since the announcement of the early French elections, spreads of eurozone government bonds against Germany have risen significantly (see Chart 1), the MSCI EMU index has lost 4.1%, and the euro exchange rate has fallen.
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 14 June 2024. Past performance is not necessarily a guide to the future.
The market reaction reflects three concerns:
- The lack of fiscal discipline expected from the parties favoured in the French elections;
- The expected increase in corporate taxes, especially on the financial sector;
- The weakening of the European Union.
French public finances were already under scrutiny. On 31 May, Standard & Poor's downgraded France's sovereign rating to AA- due to an upward revision to the forecast deficit which is now expected to return to 3% of GDP no earlier than 2027. Moody's emphasises that the high cost of servicing public debt threatens the sustainability of French public finances. All the most likely scenarios on the outcome of the elections involve a high risk of fiscal slippage. Based on the 2022 election manifestos and recent statements, it can be anticipated that both RN and the NPF parties will adopt policies that would further increase the deficit, like the repeal of the recently approved pension reform, with an impact on the deficit of around 1% of GDP per annum. The spectre is that of a crisis similar to the one triggered in the UK by the Truss government in 2022. If this happened, the spread between French OATs and German Bunds could widen well beyond the 28 basis points recorded after Macron's dissolution of the NA.
Unsurprisingly, concerns about French public finances have affected other parts of the European financial market. First, sovereign spreads of Italy, Spain and Greece have increased to a similar extent to that of France although the incumbent majorities in Italy and Greece did well in the EU elections (see Chart 1). The increase in sovereign spreads burdened European stocks. The financial sector has been particularly affected, with its index falling by around 6.5% in a week (see Chart 2). Banks and insurance companies have been penalised for two main reasons:
- They hold large portfolios of government bonds, the prices of which have fallen;
- There are fears that the new French government will introduce a windfall tax on extra profits, with the strong profitability of the financial sector in recent quarters making it a likely target, and that these policies could be replicated in other countries.
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 14 June 2024. Past performance is not necessarily a guide to the future.
It is also notable that a French government led by the RN or the NPF risks weakening various European institutions. Parties from both groups have in the past criticised the European Union (EU) and the transfer of sovereignty by national governments. As noted by Moody's in a recent report, "[g]rowing political polarisation and the increasing influence of anti-EU parties […] risks hampering the effectiveness of EU institutions".5 The areas most at risk are the EU budget and common funding on issues such as defence and the energy transition, as well as foreign policy.
With all this in mind, it is important to note that since its birth after the Second World War, the EU has relied on the fundamental agreement on many core issues between Germany and France. If a French government led by openly anti-EU parties is an imminent risk, one should not ignore the advance in Germany of the far-right party Allianz für Deutschland (AfD) which has said it wants a referendum on Germany's exit from the EU.6
If the forces against further European integration continue to strengthen, the future of the EU would once again be questioned. It is perhaps telling that the yield spread between French and German government bonds has suddenly risen to the highest level since the "whatever it takes" speech of European Central Bank President Draghi in July 2012 at the height of the eurozone debt crisis. These concerns help explain the fall of the euro against most currencies since 7 June (see Chart 3).
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 14 June 2024. Past performance is not necessarily a guide to the future.
In conclusion, the upcoming parliamentary elections in France risk having lasting consequences for the future of the European Union and for European financial assets. It seems unlikely that market sentiment will improve much until the attitude of the new government on the most sensitive issues for the markets becomes clearer. An extended period of volatility in European assets prices cannot be ruled out also considering the advance of eurosceptic parties in the main countries of the European Union.
1 In the French Parliament, the National Assembly is the lower house and exercises legislative power.
2 The members of the National Assembly are elected with a two-round system. If in the first round no candidate obtains an absolute majority of cast votes, provided that they represent at least 25% of eligible voters, the candidates who have obtained the support of at least 12.5% of eligible voters go to a run-off where the winner is decided on the basis of the simple majority of cast votes. If only one candidate meets the requirement in the first round, the two candidates with the most cast votes go the run-off vote.
3 See https://www.lefigaro.fr/elections/legislatives/legislatives-d-apres-la-projection-des-europeennes-les-macronistes-et-lr-menaces-de-disparition-20240612
4 The New Popular Front includes four parties: La France Insoumise, the French Communist Party, the Ecologists, and the Socialist Party.
5 See https://www.moodys.com/research/Sovereign-and-Sub-sovereign-Europe-Populist-surge-raises-institutional-political-risks-Sector-In-Depth--PBC_1406179#3-Discussion
6 See https://www.politico.eu/article/far-right-leader-wants-germany-to-vote-on-a-dexit/
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