Jump Start podcast: US inflation, UK's new government & French election (4:36)
CIO's Christopher Swann on US inflation, and the market impact of elections in the UK and France.

Thought of the day

Politics has taken center-stage in Europe as investors assess the outcome of the French legislative election. The second round of voting on Sunday ended without any party gaining an absolute majority in the National Assembly. The large number of candidates dropping out of the race after the first round and the highest voter turnout in four decades (near 67%) helped prevent the far-right Rassemblement National (RN) party from gaining a majority. The center-left’s strategy to band together to form a “front républicain” against the RN paid off.

Final numbers show the Nouveau Front Populaire (NFP) won 182 seats, well below the number needed for an absolute majority (289) and not enough to ensure political stability in France, in our view. Centrist party Ensemble captured 168 seats, surprising with a second-place finish. The RN came in third with 143 seats, followed by Les Républicains (LR) at 45 seats.

The president, Emmanuel Macron, should now appoint a prime minister who is able to form a government. There is no strict timetable for forming a government, but no legislation or regulations can be passed until one is formed. In the absence of a clear majority, the risk of institutional deadlock is significant.

What do we expect?

We see three potential outcomes. First, Macron could appoint a prime minister from the party with the highest number of seats at the National Assembly (in this case, the NFP). While it is customary for the president to appoint a prime minister from the largest party, there is no legal obligation to do so. A confirmation vote in parliament is not required, but in practice the prime minister needs to be backed by a majority given the power of parliament to bring down the government through a vote of no confidence.

A technocratic government—i.e., one where the government is composed of technical experts and not politicians—is another possibility, but we believe it is unlikely. A third option would be a government composed of moderate parties (PS [Socialist Party] + moderate right + Renaissance). Both of these outcomes would likely be short-lived, in our view. However, according to Article 12 of the French Constitution, the president can only dissolve the National Assembly after 12 months.

An NFP government would likely try to undo the recent pensions and unemployment reforms, increase the minimum wage, and not engage in fiscal consolidation, in our view. We believe the NFP's program, if implemented as proposed, may lead to a significant deterioration in the already high budget deficit.

Without an absolute majority, passing legislation would be challenging, but there are options. For example, the government could attempt to secure a majority on a case-by-case basis for each law. Alternatively, it could invoke Article 49.3, which would allow it to pass a law without a vote. However, this option comes with the risk of facing a motion of no confidence. If a government loses a vote of confidence, it will assume a caretaker role until a new one is appointed.

One of the key focus points of any new government will be the passing of a 2025 draft budget. A minority government can still pass a budget by bypassing the lower house. This can be achieved either by using Article 49.3 of the constitution, or using Article 47, which would turn the budget proposal into a formal law after 70 days or provide the government with means to spend and collect taxes.

What’s the likely impact on financial markets?

Equities: A hung parliament is likely the best scenario for European equities. We view this as the best-case outcome from the second round, but volatility may continue. French stocks had fallen around 4% since the election was announced on 9 June. However, on Monday morning, the CAC 40 rebounded from early losses to trade 0.5% higher at the time of writing, while the pan-European Stoxx 600 was up 0.3%. Yet, political uncertainty remains elevated in France, and the election has heightened focus on France’s precarious debt situation, with government debt levels and the fiscal deficit both elevated. We therefore expect some political risk premium to remain priced in, compared to a month ago, and expect the market rebound to be limited to the very near term, with foreign investors still likely to view Europe’s political backdrop as uncertain.

Fixed income: Unappealing relative value. The fundamental outlook for French sovereign credit is deteriorating, in our view, with a high and rising debt ratio, elevated fiscal deficits, and an increasing cost of funding. In our view, credit rating agencies are unlikely to act in response to the election results; instead, they will likely wait for effective legislative changes in fiscal policy. A key event to watch will be how the new French government will address demands from the European Commission with respect to its excessive fiscal deficit. Considering the political timeline, more clarity will likely only emerge on this front around November.

Since the first round of the election, after which the more extreme parties looked unlikely to secure an absolute majority in parliament, risk sentiment has improved and risk premiums on French bonds have fallen. The spread on 10-year OATs relative to German Bunds has decreased by 16bps from its peak at 81bps, while the French corporate bond market, particularly banks, have also rallied. However, despite the recovery, spreads remain above pre-election levels, and we don’t expect them to recover fully in the near term. On Monday morning the OAT/Bund spread was little changed at 65bps.

Due to the potential political gridlock, the limited visibility on political/regulatory decisions, and the possibility of further negative rating action on French sovereign debt, volatility on French assets will likely remain elevated, in our view. Any statements hinting at potential confrontations with the EU commission could conceivably cause spikes in yields.

Given the traditionally limited trading activity over the summer period, the comparatively large proportion of foreign investors holding French bonds, and the European Central Bank’s program to shrink its balance sheet, market moves could be exacerbated by limited liquidity and challenging market technicals. With further upside limited, we see better opportunities in countries with a more stable debt trajectory. In the corporate space, we also continue to like the bonds of quality issuers.

The impact on the euro is likely to be limited, but there are nuances. The euro has drifted slightly lower in early trade on Monday, toward 1.08 against the US dollar. The risk premium on the euro looks like it has already faded to some extent. However, should the left wing form a government and impose its strategy, EURUSD is likely to dip below 1.05, given the expansive fiscal implications of the party’s manifesto at a time when France is likely to face an Excessive Deficit Procedure (EDP). If the new government is made up of moderate parties, EURUSD should remain close to 1.08, in our view.