French elections: an unexpected reaction to an expected outcome

At the beginning of June, the outcome of the European elections was more or less in line with expectations in terms of the distribution of seats. In the end, the centre held well, with both the European People’s Party and the Socialists and Democrats still gaining some seats on a net basis. The big losers of the elections were the liberal Renew party and the Greens. Both lost about a third of their seats to those more at the extreme right of the political spectrum.

The big surprise, however, was the decision of President Macron to call for new French legislative elections after his party's huge, but expected, electoral defeat at the European level. Normally, France does not hold legislative elections until 2027, at the same time as presidential elections. It took some time, but Macron finally admitted that the main reason for his call for early elections is to avoid a Le Pen presidential victory in 2027, which could go hand-in-hand with an absolute majority in the French parliament. We believe that this is a rather naive reasoning on his part as one of the main strengths of extreme and populist parties is to successfully put blame on those who have governed before.

For us, the call for early elections this year was not unexpected. But the timing of it was. Next year’s budget negotiations were already in the doldrums. The French deficit in 2025 is already expected to exceed 5% and the likely initiation of an Excessive Debt Procedure (EDP) by Europe will require a very difficult mix of large spending cuts and substantial tax increases.

As a result, we expected new elections to be called after the summer when these negotiations would continue to fail, and Europe would formally initiate the EDP. In this context, the spending plans of both the extreme right and the left-wing coalition would double next year’s budget deficit to over 10% which is very unsettling for markets.

The size of the market reaction so far is in line with what you can expect from such an unexpected announcement in Europe's second-largest economy. French spreads have risen by 30 basis points so far, and other European government bond markets have moved in a typical ‘beta move’. This means that the spreads of those countries that are perceived by the financial markets to be the riskiest have reacted the most. Italian spreads have widened in line with French spreads, and Spanish spreads have moved by half as much.

Is France already attractive in terms of spreads?

In the long term, we believe that France is attractive at current spread levels. However, as an active portfolio manager, the short term is much more important in this type of environment.

Firstly, uncertainty can only increase in the coming weeks. One of the main reasons for this is the architecture of the French electoral system. It consists of two rounds, with the second round typically pitting the candidates with the most votes against each other. In the past, this has led to the victory of the more centrist candidate, as many votes of candidates who did not pass the first round are cast for this centrist candidate.

The exact outcome of the second round is thus very difficult to poll correctly. As such, any swing in the polling of a more extreme candidate doing better or worse can quickly affect uncertainty and therefore French spreads and volatility. It is never a good idea to (re)position yourself when both uncertainty and volatility are that high.

Secondly, some note that French spreads are at the same level as in 2017, when Le Pen’s gains in the polls increased fears of a Frexit, i.e., France leaving the European Union. Therefore, they see current spread levels as attractive as a Frexit is not in the cards.

We don’t agree as this fails to take the relative spread movement and the market context into account. In 2017, before the Frexit risk started to be priced in, French spreads were at 20bps over Germany. During this period, they rose to 80bps, hence a relative movement of 60bps. Before the recent call for an early election, French spreads were already at 50bps. Therefore, although they are now at the same spread level as in 2017 at 80bps, in relative terms the movement has only been 30bps. Consequently, in a risk scenario, spreads could easily rise to levels above 100bps.

Another important point is that we agree that a Frexit is not in the cards. However, in 2017, the ECB was extremely active in terms of monetary policy support. This is no longer the case. As a result, because of this ECB absence, there is less of a ceiling on the level to which spreads can go. Currently, the only programme still in place is the PEPP programme on the basis of reinvestments. However, even this programme will be halved next month and will therefore never be able to cap French spreads as it has in previous years.

Finally, if we look at the evolution of French spreads, we can see that other countries are also suffering from this typical 'beta move' that we described earlier. This also means that there are interesting investment opportunities in other European countries that have opened up. Therefore, we believe that it is better to monitor the spread movements in other European countries that have a very positive medium-term growth profile and that do not suffer from such negative debt dynamics as is the case with France. Consequently, even if France moves above 100 bps, we believe that other European countries will be even better investment opportunities as their spreads should move back to pre-shock levels.

In conclusion, although France has become more attractive in the long term, in the current context of increasing uncertainty and volatility, it is the short term that matters more for your expected performance as an active portfolio manager. Ultimately, Europe’s Stability and Growth Pact will rein in excessive spending and calm markets. But also, even if Le Pen were to win a majority and become president, there are enough checks and balances in place to limit any anti-EU sentiment and actions. As always, patience is the key.