What does the new political landscape mean for the economy and markets?

Commentors: Azad Zangana, Senior European Economist and Strategist at Schroders; James Ringer, Fixed Income Portfolio Manager at Schroders; Martin Skanberg, Fund Manager, European Equities at Schroders

Azad Zangana, Senior European Economist and Strategist:

The projected results of the second round of the French legislative election have provided a major political upset. The far-right National Rally (RN) and its collation partners were widely expected to be the biggest group after a strong performance in pre-election polls and the first round contest. However, collaboration between opposing left-wing and centrist parties have effectively blocked RN.

The left-wing New People Front (NFP) appear to have won the most seats, followed by the centrist coalition Citizens Together (ENS), which includes President Macron’s liberal Renaissance party. The centre-right Republicans finished in fourth place, and crucially, are not expected win enough seats to form a majority coalition with RN.

‘Prime Minister Gabriel Attal offered his resignation to President Macron on Monday, 8 July, which Macron rejected asking him to stay on temporarily "in order to ensure the country's stability".

‘The NFP coalition consists of four parties ranging in their degree of radicalism. The French Communist Party along with France Unbowed are the most extreme left-wing parties, then there is the Socialist Party (former government under Francois Holland) and the Greens.

Three possible scenarios for a new government

‘In a speech following the initial seat projections, France Unbowed’s Jean-Luc Mélenchon gave a defiant speech. He not only claimed victory for the left, but also sent a signal that he is not willing to negotiate on the policy agenda that the NFP coalition has agreed. This obviously poses an issue for how a government could be formed, or even how a minority government would operate.

‘Meanwhile, other NFP leaders were more pragmatic, expressing an understanding that the next government must deliver solutions for the population in order to avoid a future far-right government. While the focus of the left has been to reduce the cost of living (according to pollsters, the number one issue for French voters), anti-migration policies which RN has historically championed, must be included in the national conversation.

‘From here, we see three possible scenarios:

1. NFP-led minority government, which achieves very little in its own agenda, but finds common ground with RN in reducing the cost of living. Potentially also the reversal of some of President Macron’s reforms on the age of retirement.
2. Technocratic government, put in place until the next set of elections in 2027. Achieves almost no change to policy, apart from rolling over the finance bill on an annual basis.
3. A fragmentation of NFP, leading to a centrist grand coalition. Realistically, ENS is unlikely to work with the NFP in their current formation. If ENS can persuade the Socialist Party and Greens to break-away and join a centrist alliance, then it could rule as a larger minority government. On their own these groups would still be short of an overall majority, but including the Republicans provides a narrow path towards a grand coalition with a majority.

‘The scenarios are ordered from most likely to least, but even the third scenario of a grand coalition is realistic.

‘All three would see fiscal slippage, at a time when France is running a large public deficit, projected to be at 5.1% of GDP this year according to the government’s Stability Programme. The programme’s stated plans are for the deficit to fall to 4.1% in 2025 and to 3% of GDP by 2027, but these targets seem unlikely to be met given the current political landscape, and the backlash against austerity.

‘Assuming government bond markets remain stable, the net additional spending would be reflationary for the economy, and beneficial for companies. However, investors are concerned that a left-wing anti-capitalist government could impede some of the larger French companies. This would be less of a concern under a centrist coalition.

‘In the near-term, political uncertainty will remain high, but a hung parliament should limit the ambitions of the more radical policies that are being proposed. For the rest of Europe, a weakened France will limit progress in key reforms, particularly following the European Parliamentary Elections.

‘Additionally, a less austere French government could undermine the EU’s Excessive Deficit Procedure, empowering other governments to also fall foul of the bloc’s fiscal rules. This raises the likelihood of higher volatility in markets, and taken to the extreme, a new sovereign debt crisis. The European Commission (EC) will have to stand strong together with the European Central Bank (ECB) to guard against such an outcome.’

What are the implications for fixed income markets?

James Ringer, Fixed Income Portfolio Manager, Thomas Gabbey, Fund Manager:

‘Sunday’s election results didn’t bring the clarity we’d hoped. The ongoing uncertainty around the formation of government means that there remain many unanswered questions. These may take several weeks to clarify, with each scenario potentially offering very different outcomes for France’s economy and for the country’s finances.

‘As it stands, the likelihood of a hung parliament has increased once more, becoming the most likely scenario. With it comes fiscal paralysis, which given budgetary concerns is the most market friendly for now, at least until the budget negotiations in Autumn 2024.

‘In the meantime, we anticipate news flow to keep volatility relatively high across eurozone fixed income asset classes.

‘With a great deal of uncertainty already priced into French government bonds heading into the second round of the election, there was some immediate relief provided by the result. Attention is now on the extent of the left-wing coalition and, realistically, the minority NPF government's inability to fulfil their expansive fiscal manifesto pledges.

‘We think it is limited, but still the fragility of France’s fiscal position remains forefront of our minds and with the country already being put on watch by EC, it remains to be seen how the new government faces the challenges of the Excessive Deficit Procedure’s stipulations.

‘For these reasons, we’re staying neutral on French sovereign risk for the time being. In peripheral markets, particularly those more fiscally vulnerable and experiencing contagion effects, such as Italy, we are also adopting a neutral position. Relative to fundamentals, we have viewed these markets to be at the more expensive side of the range for some time.

‘Similarly, French covered bonds valuations, which have remained relatively stable compared to senior financials, are not as compelling as earlier in the year and we are less constructive.  

‘We remain relatively sanguine on broader European investment grade credit, although French risk across our strategies remain relatively low. Similar to the price action we’re seeing in the French-Bund sovereign spread, French banks – which were more vulnerable in the sell-off have already started to retrace their prior weakness.

‘At some point, we expect the indiscriminate nature of the market volatility might open up some idiosyncratic opportunities, but now is not yet the time.

‘Our sense is that the outcome of the elections will not significantly affect monetary policy conditions. While the fiscal indiscipline of member states will be of concern, it is unlikely to preclude the easing cycle the ECB has already embarked upon as disinflationary progress is made. This should offer some support to European fixed income assets over the medium term.’

What are the implications for equity markets?

Martin Skanberg, Fund Manager, European Equities:

‘The surprise announcement of French parliamentary elections saw French stocks underperform in June. France’s CAC 40 index was down -6.4% compared to a -2.6% fall for the broader eurozone index, the MSCI EMU.

‘This was in large part due to uncertainty over the business agenda of the RN, who were expected to gain large numbers of seats. In particular, shares of domestic French companies (banks, utilities, infrastructure operators) came under pressure. The nature of a snap election meant little concrete information was available as to what the RN’s plans may be. RN leader Marine Le Pen had previously indicated a desire to nationalise toll road assets.

‘French stocks then recovered somewhat with the CAC 40 returning 2.6% in the week following the first-round vote, which pointed to a hung parliament. That outcome has now been confirmed but with the left-wing alliance emerging as the largest single bloc followed by the centrists. French equities are trading slightly higher at the time of writing.

‘A hung parliament, and with Emmanuel Macron still in place as president, is likely to mean a period of uncertainty with little being achieved on the policy front.  

‘In the European Blend team, we invest on the basis of stock specific opportunities, not country views. The process of forming a new government may take some time and the question will be whether any future selling of French equities results in individual stocks becoming attractively mispriced.

‘France is far from being the only country to hold elections this year. Investors need to be able to navigate around these events and focus on the stock specific opportunities that may emerge from any resulting volatility.’