One week / one topic: French unknowables

What happened?

In recent European Parliament elections, far-right parties strongly exceeded expectations by winning in France and Italy and coming in second in Germany.

In reaction, French government bond spreads suffered in particular – the country had also recently been downgraded by S&P – as Macron called a snap parliamentary election which could easily backfire and lead to gridlock at best. (Trying to write his way out did not work…)

In the attempt to stem the rout, the French finance minister first warned that “(With the right) A debt crisis is possible in France, a Liz Truss scenario is possible”. Not content, he followed up a couple days later with: “(The left’s) program will guarantee a downgrade, mass unemployment and an exit from the European Union.”

The problem? Investors seem to believe him…

While trading political outcomes can easily turn into a fool’s game, France is now perceived to be ‘in play’ – and Europe with it.

Importantly, the blowout move in French spreads matters even more as foreigners hold 53% of French debt, and – for a country running perennial budget deficits – retaining the market’s confidence is indeed paramount.

Markets might not be seriously considering an imminent French debt default (or Frexit?!?) but the recent flight to quality away from OATs remains quite telling – despite the fact that in any case this is not 2011, since the OMT, ESM and TPI backstops are now in place.

Once markets (or society) explore a certain territory once, the bar for returning there is permanently lower – so now that investors have been primed for heightened political risk in Europe, they are more likely to rush to conclusions… potentially generating investing opportunities.

Furthermore – given France’s size and political clout – contagion risk looks inevitable for other European assets and it is indeed already happening.

While observing the fact from different perspectives, ultimately voters and markets are asking the same question: what’s next for Europe?

Our observations

• Fundamentals: French corporates have been borrowing in spades since the GFC. Despite recent, aggressive US fiscal expansion, French total debt is much larger… without of course being able to count on the Dollar’s exorbitant privilege or (still) dominant hard power.

• Price action: With the potential for aggressive new leadership and memories of the UK ‘mini-budget’ fiasco still fresh, a debt crisis in France is not unfathomable anymore. Indeed, rumours of Macron resigning led to market chaos on Tuesday — and we might well see further large moves soon.

• Investor beliefs: Anecdotally, local investors seem complacent as they think that the French electoral system should prevent the worst-case scenario. Yet no one thought that Trump could win in 2016, or that Brexit was possible… until it happened. Forewarned is forearmed.

So what?

While we did not own any French government bonds going into the event (and still don’t), we retain ‘neutral’ position levels in European equities and the Euro across our diversified, multi-asset portfolios.

As investors are discounting political risk for European equities, recent underperformance vs the S&P 500 is even more visible as US Tech stocks (which we also own) have done well as of late.

(For context, Apple added $300bn of market cap in two days)

But what about the opportunity to buy (now even cheaper) European assets, following the recent move lower? Was it all ‘overdone’? Are investors rushing to conclusions and pricing in things that have not happened yet, of that they simply can’t possibly know?

Looking at the big picture, it seems hard for these assets to outperform without US investors – who command the largest portion of global AUM by far – stepping in, venturing into so-called ‘overseas’ or ‘international’ assets.

However, not only it is well known that investors often suffer from home bias; recent news from Europe seem perfectly designed to keep foreigners away – and incidentally also drive European corporate champions to list elsewhere along the way. (Do spare a thought for Britain)

Unsurprisingly, investors across the globe have a growing preference for US stocks as outperformance provided a fertile ground for a narrative justifying this phenomenon to emerge.

At the same time – while voters lament that expensive and ambitious climate pledges are not delivering tangible benefits, and they remain fixated on (unavoidable?) migration as a threat – investors can clearly see that Europe is in urgent need of reform as:

1. There is no end in sight for its severe economic decline vs the US and Asia; and

2. The Eastern border is not secure.

As the world is seemingly spinning faster and faster, investors are losing patience with Europe’s incremental, last-minute approach to reform.

Polish political refugee – and weightlifting World champion – Jerzy Gregorek once said: “Hard choices, easy life. Easy choices, hard life.”

Who knew this would come to mind when thinking about Europe in 2024?

We should not rush to conclusions of course, and perhaps the words of EU founding father Jean Monnet – “Europe will be forged in crisis, and will be the sum of the solutions adopted for those crises” – will ring true once again.

Even so, much more pain might be needed before Europe gets ‘there’ – if it ever does.

For now, beyond the short-term volatility, higher risk premia for European assets look likely to remain in place as investors discount the uncertainty.