Macroeconomics

Despite the unexpected victory of the left in Sunday’s second round of voting in France, it looks unlikely that they will be able to form a government. The bloc has less than the 289 seats required for a majority and not enough political overlap with the rest of the parliament to form a functioning coalition. However, the much-better-than-expected result for President Emmanuel Macron’s centrist Ensemble party opens the possibility of a so-called rainbow coalition of moderate lefts and rights. Such a coalition would likely be seen by markets as the least bad conclusion of the election, but still less favourable than the status quo. However, markets will be cheered by the prospect of a pro-European parliament and one that should enable further European integration.

The next few days and weeks will be filled with uncertainty, political negotiations, and perhaps more surprises. But regardless of the make-up of the new government or who leads it, the focus will soon shift to France’s fiscal situation. The country has recently been reprimanded by the European Commission for breaching the European Union's budget rules under President Macron. A potential hung parliament risks further delays to fiscal consolidation. Even a functional rainbow coalition would still likely mean more fiscal slippage given the more moderate left is itself biased towards looser fiscal policy.

The market will breathe some relief that tail risks have been avoided but the ongoing near-term political uncertainty and broader fiscal concerns are likely to keep risk premiums elevated versus their pre-election levels. OAT-Bund spreads might tighten a few basis points more over the next few days, but we think it’s unlikely they’ll return to the pre-election range. 

The initial move lower in the euro after the projection announcement probably reflects the strong outcome for the left, but if a more stable rainbow coalition surfaces then we could see the currency strengthen slightly further. French equities look to have the most upside from here, having sold off aggressively following the surprise snap election call. 

- Salman Ahmed, Head of Macro and Strategic Asset Allocation

Fixed Income 

Even before the French election story developed, we held a cautious outlook on France’s government debt. A low propensity for growth across the region is likely to require high levels of spending from the government, which could further weigh on public debt, already in excess of 100 per cent of GDP. The promises made by the opposition parties before the election do raise the risk of a further downgrade to France’s sovereign credit rating.

As a result, our preference has been for large-cap, defensive, corporate debt. We have confidence that in times of systemic risk, high-quality national champion companies that have large employee bases in their respective jurisdictions will remain a safe investment. The government has a high stake in their success. 

We think it’s unlikely that the new French government will do anything to hurt French business. However, we continue to monitor French bank names given the risk that the election will lead to some repricing. We would consider increasing exposure on further weakness.

- Ario Emami Nejad, Portfolio Manager

Equities

Even if a coalition caretaker government emerges in France, significant reforms appear to be off the table and deficit reduction will be difficult. With such uncertainty, the prospect of any substantial risk premium compression is limited. 

With France's deteriorating public sector finances, a hung parliament skewed towards the left-wing coalition of Nouveau Front Populaire (NFP) is challenging. While markets were expecting a hung parliament, they were not expecting the NFP to win. The risk that the coalition veers left with an anti-business programme could spook them. However, such a programme will prove hard to execute given the lack of an absolute majority. 

The risk premium on French domestic stocks and French debt will clearly remain elevated until the next election - most probably in one year’s time given the hung parliament. We are likely to see some volatility around political news flow over the coming days and a possible risk-off period.  

- Vincent Durel, Portfolio Manager

We have little optimism regarding the short- or long-term outlook for the French domestic economy for the same reasons we’re gloomy about the outlook for the domestic economies of Europe generally (which represent about a third of the sales and profits of companies in continental Europe). Ageing populations, low productivity, and high and growing levels of government debt will mean growth is likely to remain anaemic. Thankfully, France’s domestic economy represents a relatively small percentage of sales and profits for continental European companies, currently around 6 per cent of MSCI Europe excluding the UK. 

There is the possibility that the shares of French financials with large global operations may have over-reacted to the domestic situation and could provide opportunities for investment. Other industries in other geographies may also have been popular hiding places in the short-term risk-off move that accompanied the news of the snap French legislative elections. 

Sam Morse, Portfolio Manager 

Multi-asset

The problems in the eurozone are now in continental Europe, not in the periphery. An institutional stalemate in France and disappointing economic performance from Germany could encourage the European Central Bank to cut interest rates both to help the eurozone’s largest exporter and partially offset internal problems. 

For strategies denominated in euros, a decrease in the value of the euro is not a concern. Indeed, a lower currency could help eurozone equities, which we did not reduce at all in the run-up to the French elections. We would be looking for opportunities on any weakness following the election. 

Overall, we are still relatively constructive on risk, although we have recently pared this back a little, increasing our protection through equity puts, which are relatively cheap at the moment. There are glimpses of green shoots of recovery in Europe, and markets will be watching for signs that they can be sustained. 

- Mario Baronci, Portfolio Manager

Some short-term volatility in the coming days is certainly possible while the dust settles. We were broadly neutral on European equities before the surprise announcement of the French election, and we maintained that view in the weeks leading up to the votes. The start of the ECB’s rate-cutting cycle should help to encourage economic activity, but overall there have been few reasons to get excited about European equities - economic activity and PMIs remain relatively weak, despite some tentative signs of improvement. 

In fixed income, we have largely preferred European government bonds to US Treasuries this year given our belief that the ECB would cut faster than the Fed and because of the large US fiscal deficit. Fiscal deficits are also an issue for the ‘core’ European economies, and we’ll be watching closely to understand the impact of France’s political stalemate on its fiscal outlook over the coming months. 

More broadly, news around the election has masked some signs of improving economic activity in Europe. However, in a reverse echo of the euro crisis of the early 2010s, it is in fact the periphery economies of Italy, Spain, and Greece that look best poised for growth while the core countries lag.

- Ayesha Akbar, Portfolio Manager