No, we do not believe that the French election poses any immediate threat to the Eurozone, in contrast to several prior Italian parliamentary and French presidential elections. The Eurosceptic Rassemblement National (RN) abandoned its goal of leaving the Eurozone, much less the EU itself, some time ago. What’s more, the relatively modest number of seats won by the RN means their ability to exert anti-EU influence will be limited. That said, the result does pose domestic political and economic challenges for France, particularly concerning its fiscal trajectory. If unresolved, French instability could in time present challenges for the European project. However, spillovers to Europe are limited for now, and we recommend holding European assets in line with benchmarks.
French parliamentary elections delivered an inconclusive outcome, though the French tradition of a front républicain endured, with rival parties coordinating to stymie the rise of the far right. Three broad political blocs of roughly equal size have emerged, representing the left (Nouveau Front Populaire [NFP], inclusive of the far-left La France Insoumise [LFI]), centre (Ensemble, to which President Emmanuel Macron belongs), and far right (RN), alongside a rump of smaller non-aligned parties. Such a split means forming a workable government may take some time. Typically, the largest party or bloc is given the opportunity to form a government, but with 143 and 182 seats, respectively, out of 577, the RN and NFP both fall significantly short of an absolute majority. It appears unlikely for either to lead a government, especially considering other parties’ reluctance or outright refusal to work with the RN or LFI. This makes an outcome that could be negative for broader Europe unlikely at this time.
The most stable outcome would be if a grand coalition with a workable majority could be assembled between Ensemble, parts of the NFP, and Les Républicains, the traditional party of the right. However, it remains unclear how willing the left and right are to make concessions and work together. Alternatively, the centrist Ensemble bloc could attempt to form a minority government with parts of the centre left or centre right. Most plausible minority governments would probably be materially short of a majority, creating unstable coalitions vulnerable to votes of no confidence. In the absence of any such agreement, the current government could persist in a caretaking capacity, or a technocratic government could be appointed with a very narrow mandate, such as to pass a budget. Each of these outcomes appear to have a material degree of instability inherent in them.
Last year, the deficit in France reached 5.5% of GDP. As a result, the European Commission recommended that an Excessive Deficit Procedure (EDP) be launched against them, with France required to make annual reductions to its deficit until it is below 3% of GDP. The concern is that without a reduction in the structural deficit, debt/GDP – which currently stands at 111% – will be on an unsustainable trajectory. President Macron had previously committed to a 1-percentage point reduction in the deficit between 2024 and 2025. During the run-up to the election, the spread between France’s ten-year sovereign bond yield and Germany’s widened by roughly 30 basis points. This increase reflected investor concerns about the fiscal policies proposed by both the NFP and RN, which were anticipated to expand the deficit and potentially jeopardise debt sustainability. While half of that widening has been reversed, spreads remain wider than when the election was called, reflecting that the instability of any government is likely to make forging a consensus on spending cuts or tax rises challenging.
France is not in a debt spiral right now. Indeed, debt/GDP should continue to decline over the next couple of years, given the long maturity of its debt, meaning that the average interest rate should be below nominal GDP growth. Nonetheless, investors necessarily keep an eye on the long-run trajectory. Foreign investors can also be averse to political uncertainty, a particular concern for France, where about 50% of debt is held by foreigners. The risks to the rest of Europe from France’s predicament, such as they are, stem from how investors react to any potential impasse that may arise between the future French government and European fiscal authorities. While some leniency may be expected due to France’s central role in the European project, excessive leniency from European authorities towards a French government failing to meet its EDP commitments could undermine the incentives for other European countries to pursue fiscal consolidation. Most notable on this list is Italy, which is also one of only two countries in the Eurozone to have a higher debt/GDP ratio (at 137%) than France. Additionally, reduced political cohesion within the French government may hinder future European integration, given France has been perhaps its strongest driving force.
France is not in crisis. However, the potential for at least a year of political impasse until fresh elections can be held could continue to weigh on sentiment, and eventually on real activity. Spillover to the rest of Europe is limited, as evidenced by the comparable performance of EMU ex France versus its global peers, and peripheral bond spreads being basically unchanged versus when the election was called. We believe spillovers will remain contained, even if the situation is a marginal headwind for the bloc in the long run. Therefore, we recommend investors continue to hold European assets in line with benchmark weights.
Thomas O’Mahony, Senior Investment Director, Capital Markets Research