A new government does not change France’s fundamental story

France’s political and fiscal woes will not go away with a change in Prime Minister. Yet, despite little prospect of reducing a large budget deficit, we see factors that mitigate market concerns.

France’s Prime Minister François Bayrou lost a confidence vote on 8 September, leaving President Emmanuel Macron with few appealing options. Our base case is that a period of consultation results in the appointment of a new PM and administration with a still-fragmented parliament. The risk here is another short-lived premiership and difficulty securing agreement on a budget by year-end. The alternative, lower probability scenario is that Mr Macron calls early elections, likely still resulting in a fragmented government, and gains for the far-right Rassemblement National. 

In either case, France’s fundamental story will not change. French government debt levels remain some of the highest among Western economies. In recent weeks, markets have priced in a lot of political and fiscal concerns, helping drive 10-year Obligations Assimilables du Trésor (OAT) yields to their highest since the eurozone sovereign debt crisis, and widening spreads between French and German government debt. We expect OAT-Bund spreads to remain wide and volatile; they could reach 100 basis points if uncertainty persists. Fitch’s sovereign debt outlook on 12 September could see another French ratings downgrade.

We expect OAT-Bund spreads to remain wide and volatile; they could reach 100 basis points if uncertainty persists

Of course, fiscal and policy failure concerns are not unique to France. They have recently driven up the cost of capital in other markets, including the US, Japan and UK. France’s budget deficit is large, and scope for raising taxes or cutting spending looks low. Its public spending could be much better deployed. The French tax system is inefficient, with social spending generally bringing few economic gains despite generally high taxes and charges. We would rather see the country roll out investment plans like Germany, but there is little political will to change the status quo. Policy paralysis mean France’s deficit is likely to stay high, and when financing costs start to exceed a country’s growth potential, as they have in France, economic risks rise.

When financing costs start to exceed a country’s growth potential, as they have in France, economic risks rise

Yet we see little risk that France’s political crisis and fiscal concerns turn into a financial crisis. In our view, the debates on debt sustainability look somewhat overstated. The private sector, where corporate balance sheets look strong and households have excess savings, is strangely absent from the assessment. A balanced current account means France does not need the rest of the world to finance its debt.

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The European Central Bank also acts as an effective financial backstop, with the Transmission Protection Instrument designed to protect against ‘dysfunctional market dynamics’ that prevent the effective transmission of monetary policy, including excessive spread widening. President Macron, whose position is assured until 2027, also provides an important element of political continuity and stability. Meanwhile, France’s energy, military and food autonomy all stand it in good stead in a changing world order.

We see little risk that France’s political crisis and fiscal concerns turn into a financial crisis

Thus far, French political woes have not resulted in any change to our tactical portfolio positioning. We had already reduced exposures to global government bonds in early August amid an increasing market focus on fiscal concerns, and a sell-off in long dated bonds in many developed economies. We currently favour investment grade corporate debt and emerging market hard currency bonds within fixed income allocations, as they offer a better risk/return profile than sovereign bonds at this stage, with all-in yields still attractive.

We had already reduced exposures to global government bonds in early August amid an increasing market focus on fiscal concerns

While euro volatility could rise amid prolonged political uncertainty in France, we think the single currency will be a beneficiary of general US dollar weakness, and target EURUSD at 1.22 over the next 12 months. We currently hold a neutral view on the CAC 40, which could see some equity market volatility. We retain a broader neutral view on developed market equities. Overall, we prefer emerging market equities where we maintain a small overweight exposure.