French politics: déjà vu

France is in the news again. Prime Minister Lecornu became the latest casualty of the French politics saga that began just over a year ago when president Macron called a surprise early election. The result of said election delivered a parliament almost equally split in three, with Macron’s coalition in the centre and Marine Le Pen’s and Jean Luc Melanchon’s parties leading the right and left respectively. Since then, Macron has tried three prime ministers from three out of the four parties within his coalition, all of whom have folded under the pressure of not having a majority in an extremely polarised parliament. It is becoming increasingly likely that Macron will call a fresh parliamentary election while remaining in place as the president. Although he is under no obligation to proceed in this manner and could try a fourth prime minister, the news over the weekend was that, in addition to growing pressure from opposition parties, discontent is growing from within.  

Polling data indicates Macron’s approval is at an all-time low. If an election is called, it’s likely his party would lose seats while Le Pen’s Rassemblement National might emerge as the winner, albeit with no clear majority. A new parliament would once again be working against the clock to draft a budget for next year. It is important to point out however that there is no such thing as a US-style shutdown in France. If no budget is finalised in time, a version of this year’s budget would apply until a new one can be agreed on. This is what happened last year when PM Barnier’s government fell. In any case, it seems that the base case scenario for markets will remain one where France is not able or willing to address her fiscal situation in earnest, with only timid attempts at reducing the budget deficit which will probably be in the mid 5s as a percentage of GDP by year end. The population, as in other countries, remain oblivious to the adjustment that’s needed to bring the debt situation under control and, therefore, so are politicians for the time being.

The fiscal challenge cannot be underestimated though. France’s debt to GDP ratio is comfortably above 100% with no signs of improvement going forward. With both tax intake and government spending being markedly higher than the OECD average, the recipe is quite clear. France, as is the case with numerous countries in the same situation, needs to reduce fiscal spending and bring the deficit under control at some stage. France’s fiscal stance is also problematic when judged against EU rules. The Stability and Growth Pact sets a ceiling of 3% of GDP for deficits and 60% for debt. France is running a deficit close to twice the threshold and a debt ratio nearly double the target. While enforcement of the rules has been flexible in recent years, pressure from Brussels and other member states is likely to rise as the European Commission restarts formal procedures in 2025. This external constraint adds another layer of risk if French policymakers continue to block credible consolidation.

To add to the pressure, a ratings review from Moody’s is due on the 24th October, and a downgrade to the single-A category would not be welcomed. The big question is when markets decide that enough is enough and force a change in both public and political attitudes towards the problem.  

Judging by the market reaction, we are not there yet. The CAC 40 stock index was down 1.3%, with banks underperforming. While BNP and Societe Generale equities declined by 3% and 4% respectively, their AT1s only did so by about 50 cents on average. Price action in Tier 2 bonds had more to do with rates selling off rather than spreads widening. This, however, is not a surprise. Corporates and banks remain in good shape and many of them are global by nature with BNP, for example, only deriving 15% of its business from France. Without a doubt, the political environment is not positive for BNP’s numbers, but it is unlikely to be a game changer either, unless we witness a proper sovereign issue. In non-banks, the situation is similar, with Morgan Stanley estimating that less than a fifth of French issuers would be affected by another round of sovereign downgrades.

While French government bonds spreads have widened significantly to Bunds (to recap, the spread over Bunds was c50bps before the snap election in June, settled at c70bps thereafter and increased to 85bps after the weekend), we think it is unlikely that we will see a sustained rally in French government bonds, just as it seems improbable that medium-term fiscal problems will be resolved anytime soon. A new parliament is unlikely to change this picture. At the same time, the credit profile of financials and investment grade issuers remains resilient, which is why the price action in these has been contained, although in a more stressed scenario we do think spreads would move. We therefore do not see an obvious trade either way in French assets at this stage and remain of the view that French government bonds are not cheap given the fiscal situation, and higher yields are almost inevitable unless the political stalemate is solved, which seems increasingly difficult.  

We of course remain vigilant to the fiscal situation, which is fragile, and to the news flow regarding potential snap elections which might change this thesis.