Europe faces policy tests, not a sovereign crisis

The trend in rising sovereign yields is global, yet markets are focused on France, which looks vulnerable from a public finance perspective. The sharp rise in French yields relative to their German counterparts has revived concerns about European fiscal stability. Yet we believe markets are pricing uncertainty rather than the conditions for a new sovereign debt crisis.

There has been much market scrutiny of the yields on French government bonds or Obligations Assimilables du Trésor (OATs). The spread between benchmark 10-year OATs and equivalent German Bunds widened to around 147 basis points in early October, the widest level since 2012. While that spread has since narrowed, the measure still surpasses the spread demanded by investors on the Italian and Greek sovereign equivalents. This reflects a market assessment that France’s recently-presented draft 2027 budget is insufficient to address concerns about the country’s fiscal trajectory.

French credit spreads are likely to stay elevated until credible fiscal consolidation programmes can pass through the French parliament, at the earliest after presidential elections in May 2027. Even then, a credible budget depends on an absolute majority in parliament, and a willingness to focus on addressing France’s debt. However, the election is more likely to deliver another hung parliament without a working majority, leaving little chance that a programme will emerge.

Markets are already pricing in substantial risk, as measured by credit default swap (CDS) spreads, which reflect a borrower’s expected ability to repay debt. Despite higher French OAT yields, we do not see a threat of a sovereign debt crisis in France or in Europe. That is because debt servicing in France remains affordable; France’s net government interest payments represent slightly more than 2% of gross domestic product, compared with nearly 3% for the UK and about 4% in Italy and the US. 

Despite higher French OAT yields, we do not see a threat of a sovereign debt crisis in France or in Europe

Furthermore, France’s current account deficit is small, and its net foreign asset position, or dependence on foreign investors, nowhere near a level that would make the country vulnerable to capital withdrawal. This is a key difference to the European sovereign debt crisis of 2012, when European countries such as Portugal, Spain, Greece or Ireland, ran large current account deficits of 7-to-12% of their GDP.

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This environment indicates that conditions are not in place for the European Central Bank (ECB) to intervene by making government bond purchases through its Transmission Protection Instrument (TPI). The ECB designed the facility to counter market dysfunctions, rather than shield governments from market reactions to their fiscal policy. Its use would therefore be more likely if there were a risk of systemic contagion to the region. 

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A shift to the right, and to EU-sceptics

We believe that we are in the process of a re-assessment by financial markets of European risk premia more widely, as political change is possible over the next year in key European countries. A shift to right-wing parties with outright wins or participation in governments of EU-sceptic parties is likely to impact national fiscal policies, as well as the EU budget, and possibly reverse some integration measures. As a result, we see this as opening a new chapter in euro weakness, possible shifts in intra-European credit spreads, and European equity volatility.

European economies including France, Spain, Poland, and Italy, are scheduled to hold parliamentary or presidential elections before the end of 2027, and snap elections in Germany cannot be excluded. Considering the disillusionment of European voters with incumbent governments, visible in low popularity ratings, political change is a realistic scenario.

We see this as opening a new chapter in euro weakness, possible shifts in intra-European credit spreads, and European equity volatility

Opinion polls and prediction markets point to the potential for conservative and EU-sceptic parties to strengthen their positions in each of these economies. While the outcomes are uncertain, investors are weighing the implications for each state’s fiscal policy, EU budget negotiations and the pace of future European integration.

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A more national, less European EU

While voters will undoubtedly concentrate on immigration policies, security and other high-profile political questions, financial markets will focus on fiscal policy and disruption risks to EU mechanisms and cohesion.

In France, the threshold for achieving an absolute majority in parliament is high. Therefore, the likelihood of a coalition or cohabitation agreement is strong, creating policy gridlock on many of the key economic policy questions. This makes it unlikely that France will be able to carry out drastic fiscal reform, and fixed income markets will likely keep French OAT-Bund spreads elevated.

Disruption to central EU mechanisms is also possible. The EU 2028-2034 budget framework is one area of potential disruption, if any of the elections were to re-open negotiations on national contributions to the EU budget, or to demand rebates. Other areas of European integration, such as for example electricity pricing rules, could also be challenged, creating significant shifts in the European energy market and intra-European tensions.

Highly indebted European countries, such as Italy or Greece, which have managed to improve their fiscal imbalances, have largely benefited from a ‘European integration’ movement in their sovereign bond yields. If markets increasingly price France in line with ‘BBB-’ rated European sovereigns, French CDS spreads should converge towards the 60-to-70 basis point range, broadly in line with Italian and Greek spreads today.

While we see some moderate upside in eurozone equities, we believe they will underperform US stocks

Broader investment impacts

The euro has entered a new phase of weakness against the US dollar as the eurozone’s growth continues to lag the US economy. Expectations for US Federal Reserve policy rates have widened the dollar’s interest rate advantage, and underpinned the US currency’s strength. The rising political risk premium ahead of key European elections will continue to weigh on the euro. We have therefore lowered our 12-month EURUSD assumption to 1.09, within a range of 1.07 to 1.12, mostly reflecting a more positive US dollar outlook. However, any deterioration in the prospects for passing the EU’s 2028-2034 budget would reinforce this trend, and become more pronounced if the far right were to win the French presidential elections next year.

While we see some moderate upside in eurozone equities, we believe they will underperform US stocks. We have therefore shifted to an underweight in European equities, and an overweight in US equities in portfolios, reflecting a more appealing US earnings outlook and greater scope for US valuations to recover. French equity market valuations still have potential downside, if OAT-Bund spreads stay wide, as stocks have not yet caught up with the most recent spread moves.

For investors, the implications of current concerns over European debt are more about relative opportunity and selective positioning than systemic risk. We see some pressure on global yields abating, which should ease some of the pressure on France, as the sell-off in bonds looks overdone. We also do not think that risks around elevated yields, higher interest rates and geopolitical risks outweigh the positive tailwinds of resilient global growth and rising earnings. While political developments will weigh on the euro, widen dispersion in European fixed income markets and create equity market volatility, we maintain our pro-risk stance in portfolios. This includes an overweight to equities, and a constructive view on the US dollar.