Investors Are Not Happy With The French Election Results

A month ago, the French president, Emmanuel Macron, called for snap national elections in response to hefty gains made by far-right groups in the European Union elections held on 9 June. His surprise decision spooked investors and traders alike and added uncertainty to Europe’s future political direction.

After new Parliamentary elections were announced, investors’ key fear rested around the notion that if nationalist and populist politicians were to take power, they would initiate extensive spending campaigns that might hurt France’s fiscal position, undermine its standing within the European Union, and possibly destabilise its relations with the United States. As concerns over the nation’s finances began to mount, the euro weakened, while French bonds sold off, raising the yields.

In the first-round vote, as expected, the far-right National Rally (RN) party of Marine Le Pen and Jordan Bardella came out well ahead of its opponents. The alliance of progressive forces known as the New Popular Front (NPF) polled second, while President Emmanuel Macron’s liberal coalition, Ensemble (Together), trailed in third place.

Market Reaction to Elections

The market’s initial reaction was positive: the euro recovered, while European stocks and bonds rallied. ‘It was more of a relief rally, as RN did not win as many votes as was previously feared,’ said Kar Yong Ang, Octa analyst, adding that the overall uncertainty remains in place. Significant macro risks will not disappear until the results of the second round of voting are published and the new government is formed.

The market’s reaction to the second round of voting was relatively muted. Although RN came only third, no single political party or alliance of parties won a clear majority, meaning that forming a new government would require lasting and possibly painful negotiations. ‘Although the worst-case scenario has been avoided, and the RN party will be kept from power for now, France’s election results still point to a hung parliament. French politics faces a period of volatility, uncertainty and possible gridlock,’ said Kar Yong Ang, Octa analyst, adding that political turmoil will continue to cloud the outlook for European stocks and bonds.

Indeed, the French benchmark stock market index (CAC 40) is still down some 4% even as EURUSD has managed to recover. At the same time, the spread between French and German 10-year government bonds remains elevated, meaning that investors continue to demand additional risk premium for holding French bonds over German securities, which are ostensibly safer and are viewed as a key benchmark. Furthermore, the recent EURUSD recovery was more due to the disappointing U.S. macroeconomic statistics rather than the result of the underlying strength in the Eurozone.

Investors aren’t very keen on political uncertainty. If France fails to deliver a functional government with fiscal discipline, investors will flee to safety, selling French bonds and the euro, pushing bond yields higher. If borrowing costs were to start rising and France’s problems spread across the continent, other debt-laden Eurozone economies—particularly Italy—could be severely impacted.

ECB Response

This would potentially threaten the stability of the single currency, the euro. However, it would not be the first time that the Eurozone would face a challenge of such kind. The previous debt crisis of 2009–2010 was avoided thanks to resolute actions by the European Central Bank (ECB), which stepped in and lowered interest rates while providing cheap loans of more than one trillion euros to maintain money flows between European banks. However, unlike the countries at the heart of the previous crisis, France and Italy boast significantly larger economies. Therefore, avoiding a crisis this time will be much more complicated.

Although the ECB is widely expected to cut interest rates this year, the scale of its actions is not significant. Currently, interest rate swaps market data imply roughly 40 basis points (bps) worth of ECB rate cuts by the end of the year. However, even these minor steps are not guaranteed. ECB officials have recently started to advocate a more cautious approach to policy easing. Last week, Gabriel Makhlouf, an ECB official and the Governor of the Central Bank of Ireland, expressed his preference for only a single additional interest rate cut this year.

He emphasised the need for further evidence that inflation is on track to reach the ECB’s target of 2%. Another ECB policymaker, Pierre Wunsch, acknowledged that the next interest rate cut is a relatively straightforward decision. However, he warned that subsequent actions should be data-driven, waiting for concrete evidence that inflation is definitively on a path towards the ECB’s 2% target.

Finally, Christine Lagarde, the ECB President, indicated not so long ago that there was no urgency to cut interest rates as economic developments were not favourable yet. Indeed, while Eurozone inflation dipped slightly in June, a key measure of price pressures that excludes volatile items like food and energy stayed at 2.9%, above the ECB target.

France’s Challenges

France has about two months to sort out its internal divisions and develop a new government. ‘The next big test will come at the end of September, when the National Assembly votes on the country’s budget, which must include spending cuts. However, given how fragmented the National Assembly is, plugging the holes in the budget will be challenging,’ said Kar Yong Ang, Octa analyst.

This presents a significant risk to the Eurozone. Indeed, France’s public finances have been under scrutiny long before the elections were announced. In May, S&P, a credit ratings agency, lowered France’s long-term sovereign credit ratings to ‘AA-’ from ‘AA’, citing a deterioration of budgetary position. Moody’s and Fitch, fellow credit rating agencies, have also expressed concern that the political uncertainty arising from the elections could negatively impact France’s creditworthiness.

France’s budget deficit is around €154 billion or 5.5% of its GDP (gross domestic product). Unfortunately, the country cannot grow its way out of this hole. The economy expanded at a meagre 0.2% rate in Q1, and the Bank of France projects GDP to grow at just 0.1% in Q2. Therefore, budgetary cuts are the only option for France to reduce its deficit.

‘We have to wait and see how the negotiations unfold. If the ruling parties fail to reach a consensus and do not adjust their ambitious spending plans, the market’s response will not be pretty,’ said Kar Yong Ang, Octa analyst, adding that French politics can trigger a massive risk-off move in the Forex market at any moment. ‘Depending on the magnitude of the uncertainty, EURUSD may potentially drop anywhere between 1.07900 and 1.06500,’ added Kar Yong Ang.

Global Implications

Emerging markets may also be affected by the development in Europe. ‘A risk-off move in financial markets implies a flight to safety, which means that investors and traders would be buying the U.S. dollar, making it more valuable for holders of other countries,’ said Kar Yong Ang, Octa analyst. As a result, the Malaysian ringgit and Indian rupee may suffer. Gold, on the other hand, will shine even against the backdrop of appreciating greenback.

About Octa

Octa is an international broker that has been providing online trading services worldwide since 2011.