Blog: You, us, everyone

What happened?
Sunday, June 10, 2024, France’s presidential party performed poorly at European elections while the historically Far-Right party Rassemblement National (“RN”) took almost one-third of the votes. In this context, there are three important observations: 

1. Over the past years, while promoting standard subjects of societal welfare and governance, they stopped endorsing FrExit, Marine Le Pen’s RN has become more a main-street party, all other than her father’s far-right extremist approach.  
2. The participation rate was at the highest in 30 years for European elections in France. 
3. Having experienced for the last 60 or so years a democratic alternation between a cluster of socialist-oriented parties and a cluster of republican parties, the French population is ready to experience a different kind of government.

Given the above, Emmanuel Macron – currently presiding over a minority government – decided to call snap legislative elections. While this was becoming increasingly likely at some point in 2024, the timing took many by surprise.

The quintessential question is whether the French voters will confirm in this snap election the direction indicated on June 10, 2024. On many historic occasions, French voters have not confirmed a given trend, hence the mess was greater afterward than before. 

What’s next?
The French legislative elections will take place over two rounds on June 30 and July 7, while the UK general election will take place on July 4. French voters will elect 577 MPs through a 2-round system. Any candidate with more than 50% of votes in the first round is elected directly. If no candidate gets more than 50% of votes in the first round, all candidates with at least 12.5% of the votes can run for the second round and the candidate with a relative majority at the second round will be granted the MP seat. On the back of this setup, a rather complex system of strategies and alliances will be set up between now and the election date. These arrangements aim to maximize any party’s chance to place its key people. 
 
An oncoming co-habitation is highly likely
The main consequence of a parliamentary election is the nomination of a new Prime Minister and its Government. Under the French constitution, the Prime Minister (PM) is appointed by the President but the PM also needs a majority in Parliament to pass laws. This means that, if the majority in Parliament comes from a different party to that of the President, the President has no other choice than to choose a candidate from this party. This - dubbed “cohabitation” - has happened three times under the fifth Republic (since 1958). In such a context, the President remains in charge of foreign affairs, but domestic affairs are run by the Prime Minister.
 
Latest political news flow
According to a survey by Toluna Harris Interactive for Challenges, M6 and RTL conducted on Monday, the RN would win 235 to 265 seats (from 88 currently), just shy of an outright majority. However, other right-wing parties such as Reconquête and Les Républicains seem likely to join forces in some shape or form with the RN, increasing materially the probability of a majority for a far-right alliance.
 
An alliance of left-wing parties has emerged this week, one of the proposed key amendments, if elected into power, is to reduce the retirement age to 60 years.

At this stage, as the traditional parties have mostly vanished in France, the three most likely outcomes seem to be:

1. A hung parliament with a very large share of RN MPs and a comfortable majority of MPs from parties with political agendas historically viewed as extremist and a self-centered approach such as “Make France great again”!
2. A slim majority for a far-right alliance.
3. A far-left alliance-based parliament with an extravagant political agenda of making people work less, more government spending (financed through higher taxes for rich people and corporations) as well as nationalizations of entire industry sectors. 
   

The probability of a centrist-based coalition is highly unlikely.

The high probability of a “Miss Liz Truss” moment for France 
By either decision, the fiscal trajectory, French finances are already quite stretched, is reaching a new level of vulnerability.  A far-right and a Far-Left majority government are highly likely to be seen as fiscally dangerous in the context of a precarious fiscal situation. 

Either election outcome is seen as fiscally unsustainable, hence the probability that financial markets test the financial and fiscal solidity of France should be seen as high – a “Liz Truss” moment comes to mind, only with a more turbulent political background. Mitterand’s early days in the office along with recent non-mainstream parties in peripheral countries also spring to mind. The pattern is often the same: fiscal reality and financial market constraints force a non-mainstream agenda back towards a more reasonable path. However, in some cases, acute or prolonged financial market volatility is required to force convergence.
 Image source: Bloomberg, Eurostat, IX-7 Asset Management SA

 
Considerations for investors:

• OAT: the OAT market exceeds EUR 2tn (similar size to BTPS). The aggregate amount of French bank EUR-denominated bonds is estimated to be around EUR 240bn across the capital structure;
  
• Rating actions: France was recently downgraded a notch by S&P to AA- Stable (Aa2 Stable at Moody’s and AA- Stable at Fitch). Moody’s has already signaled that the announced elections increase the risk of downgrade and if OATs continue to widen, one should expect the outlook to move to negative or negative watch. If France is downgraded below AA-, this would have material and negative implications for OAT & proxy bond demand. 
• EGB contagion: BTPS spreads have widened materially since Juen 10, 2024. Chances are high that a deeper and sustained widening of OATs increases the risk of a wider sovereign crisis, with fiscally vulnerable countries the main victims – hence, systemic issues are back in the playground. 
• EU Banks: after the GFC and subsequent sovereign crisis, regulators and banks’ management teams have been busy trying to kill the so-called doom-loop between government bonds and bank credit. This is dear also to the ECB given the obvious ramifications regarding the effective transmission of monetary policy. Contagion risk is indeed lower given changes to balance sheet compositions however, it would be foolish to think that there would be no contagion if sovereign credit spread volatility spiked – this contagion however would be more technical than fundamental. One could also describe the likely downside as lower than used to be the case. What’s more, many countries affected by the sovereign crisis in the 2010-2012 period have now put their fiscal house in order and should be seen as relatively insulated from such events / have a lower beta to OATs/French banks (Ireland and Portugal in particular have done very well). Last but not least, large EU banks are now in very solid financial shape, whether one looks at capital, asset quality, liquidity or profitability – these are not the same credits as in the 2010-2012 period;
• ECB spread sensitivity: interestingly, unlike the 2017 French presidential election, the ECB is shrinking its balance sheet while OATs’ gross and net supply are elevated. This makes for a weak technical set-up. As per the above, there is a level of spread and/or spread volatility where the ECB turn uneasy about price developments. Various programs are in place to facilitate ECB intervention however, there is likely to be significant moral hazard involved and, in all likelihood, any potential ECB circuit breaker – if necessary – would come with fiscal strings attached
• Macro and monetary policy implications: fiscal and financial instability dent consumers, corporates, and investor confidence, thereby depressing demand. As fiscal consolidation becomes more likely, a softer nominal growth trajectory becomes highly likely as various economic agents look to deleverage. This would likely push inflation below current forecasts and ECB objectives and for a prolonged period.
• Frexit? This may sound fancy in the wake of the disastrous situation of England after Brexit, but people are willing to experiment with about anything to get change. 

Not that we don’t like Europe, but we have long argued that its political setup is wrong. As of now, public opinion is overwhelmingly in favor of the euro, but recent surveys suggest that public opinion is tired of being ignored. Things can change relatively quickly but for now the probability ratio for a more population-centered system being put forward is low. 

Things can change, however, either should be treated as unrealistic for now.
 
Outlook: big opportunity in the making
As market participants seek to minimize various risk sensitivities ahead of the election, we expect a risk-off, volatile and erratic market pattern in the short term (1-2+ months). A soft CPI report and/or dovish-leaning FOMC may help contain volatility in assets less directly exposed or linked to EGB spread vol. More generally, we expect disinflation to resume more clearly from here while the job market continues to soften, enabling most DM CBs to cut by more than what short-term interest futures are pricing. If so, this would help contain the risk fallout (e.g. lower IR vol, lower risk of credit fund outflows). However, it would also likely come with a softer nominal GDP growth outlook, implying upside risk to debt/GDP trajectories for France and Italy and a more acute requirement for a clear fiscal agenda.
 
Depending on the depth of the move, buying risk shortly ahead of the election or at pre-set levels might become opportune. Priority should be given to government-issued of Ireland, Portugal, and Spain, GBP-based- investors could look at non-FR/IT snr/t2, Spanish/Portuguese/UK AT1s, and/or short-dated high reset bonds. Potentially, selected FR snr/covered or beaten down AT1s from high-quality issuers might also be worth a look in small size.
 
We already like core EGBs, Gilts, and USTs, with a preference for 3 to 5-year maturities. We think such assets would help navigate the coming weeks with less volatility (with risk asset/govt bond correlation likely to shift if the move extends), thereby placing one in a position of strength to take advantage of the very attractive opportunities that are likely to present themselves in relatively short order.
 
French Credit strategy
The FR country risk was well-flagged already in the past. The rationale: there is little country risk premium embedded in most FR corporate bonds, i.e. the opportunity cost of having French credit is greater than elsewhere.