Professor Jeremy Batstone-Carr, European Strategist
“The age of abundance is over”
– French President M. Emmanuel Macron
Financial markets are discounting mechanisms. That is to say that they take the sum-total of all knowledge and attempt to project what is known into the future. Generally, this works pretty well when applied to economics and other factors germane to financial asset performance. But what markets typically struggle to price effectively are political outcomes, particularly when those outcomes are themselves mired in uncertainty. Imagine then, the shock delivered by French President M. Emmanuel Macron’s surprise decision on 9 June, prior even to the final results of EU parliamentary elections, to dissolve his country’s lower house National Assembly and hold snap elections over, as is usual, two
consecutive weekends on 30 June and 7 July. M. Macron’s move may have been prompted by his political grouping’s poor showing in EU elections, but it bears all the hallmarks of far greater domestic considerations. The response in the financial markets was immediate, the differential between the yield of French government bonds and their more stable German counterpart spiked higher while the French stock market fell sharply. But while France is clearly the epicentre of reawakened political risk, what chance is there that the contagion might spread?
WHAT IS IT THE EU FEARS?
In Nick Roeg’s film Don’t Look Now, the Italian police inspector regards the leading actor (played by the sadly recently deceased Donald Sutherland) with a gimlet eye and asks quietly, but pointedly, “What is it that you fear?”. For the European establishment, inheritors of what, even after more than two decades, remains a work in progress, the challenge lies in how to address the evolution of new and politically more extreme political parties springing up across the continent without fracturing, perhaps terminally, the ongoing project. M. Macron’s unpopularity with voters on both sides of the political divide in France threatens just such a destabilising outcome. Whilst financial markets struggle effectively to price political outcomes, they respond even less favourably to potential instability. So, whilst the EU parliamentary elections delivered a strengthening in the centrist bloc from which Commission President Ms Ursula von der Leyen (whose nomination for a second term must be ratified by the incoming legislature) derives her support, populism antagonistic to the status quo is on the rise, be it in Italy, Hungary, Poland, the Netherlands, France and even Germany where the Alternative for Deutschland Party continues to make headway ahead of national elections next year.
WHAT ARE THE ISSUES?
The focal point for the disaffected is, as is so often the case, immigration. Large numbers of both legal and illegal immigrants crossing regional and national borders have created tension and pressure on public services, a tension most notably illustrated by the collapse of the Netherlands government in the autumn of last year. But whilst immigration may serve as the lightening rod, behind it lies deeper macroeconomic issues associated with sclerotic economic activity that persistently bedevils the Euro Area
and even more pertinently, a high cost of living which, while easing, is doing so only very slowly against a backdrop of still high interest rates, both in nominal and inflation-adjusted terms even despite
the European Central Bank’s recent decision to embark on a small downward adjustment.
But for Brussels and Strasbourg a deeper concern lurks. Policies enacted during the pandemic may have been aimed, firstly, at softening the blow to both households and businesses caused by
lengthy lockdowns and immediately thereafter to offset the adverse impact of an energy crisis. But with the direct consequence of sanctions imposed on Russia following its invasion of Ukraine, the result has proved to be a spiralling deterioration in the public finances of many but the most hair-shirted of regional members.
These immediate crises having passed, the European Union’s supra-national bodies are now seeking both to regulate and thereafter reduce the public debt and deficits of member states back towards, if not immediately to, levels more commensurate with overhauled fiscal rules deemed an essential part of belonging to the single currency zone.
Behind this compulsion lies a key pillar around which the Euro Area was originally created; that in order to participate in the project, individual states must accept that, firstly, their public finances are a matter of concern to all members and that to enjoy the benefits bestowed by a common short-term interest rate set by the Central Bank, a disciplined approach to fiscal policy is a prerequisite. Secondly, member states must participate in EU-inspired initiatives such as the climate agenda and defence, neither of which come
cost-free. What European institutions want is for national governments to behave responsibly, and behind them their populations, voters, to behave as good Europeans and act not in self-interest but for the
greater good of the region more generally. Whilst a worthy aspiration, the reality is that populations typically put domestic considerations foremost during periods of economic hardship and it is this realisation that has resulted in populist political parties pursuing agendas antipathetical to wider goals, encouraging financial markets to drive longer-term interest rates higher.
In partial recognition of this fact, the European Union has rowed back on its demands, no longer requiring deeply indebted states to bring debt-to-GDP ratios down to the 60% level envisaged by pre-existing treaty immediately, but to do so over time. This lesser objective, merely encouraging fiscal policy discipline rather than enforcing policy which would result in immediate economic depression and by
extension the far greater threat of regional fragmentation, comes with guidelines as to how spending and taxation might be applied. This relaxation has already borne fruit; the hitherto avowedly anti-European ‘Roman firebrand’, Ms Georgia Meloni, leader of the Italian Brotherhood alliance and Italy’s first female prime minister, has overseen an adjustment in the country’s fiscal policy objectives to the extent that whilst still loose they do at least fall within pre-existing ‘golden rules’. In consequence it is thought possible that her administration might survive a full term in office, remarkably the first time that has happened in Italy since WW2.
FRENCH POLITICS: LET THE PEOPLE DECIDE
Unlike his neighbour to the south, M. Macron has failed to deliver on the EU’s fiscal requirements. Whilst successfully raising the French pension age from 62 to 64, this has come at a huge cost in terms of his personal popularity and that of his centrist political vehicle, La Republique En Marche (LREM). In an effort to improve France’s competitiveness, the already minority LREM administration has successfully lowered social security charges and company tax rates aimed at reducing business costs, but the country remains mired in bureaucratic red tape which has enraged powerful and deeply reactionary unions whilst simultaneously forcing a rebellious population onto the streets in protest.
It is this sense of frustration that has encouraged the continuing rise of the French political right (National Rally, NR) led by Mme Marine Le Pen and M. Jordan Bardella and a resurgent political left, now united as the New Popular Front (NFP: Nouveau Front Populaire). These groupings want power and have seized on the opportunity seemingly gifted upon them by the decision to dissolve parliament. Prior to the vote, public opinion polls had the National Rally at 36%, the NFP on 30% and LREM on 20.5%. If accurate (and
despite the National Rally’s strong showing in the first-round Assembly elections, final figures are very much open to question given the significance of tactical voting and turnout in French elections), this would translate to between 220-260 seats, 185-215 seats and 70-100 seats respectively in an Assembly where 289 seats is the threshold for majority control. In order to curry favour (and financing), the National Rally has moderated its position on a number of key issues without, apparently, alienating its traditional support base. However, and despite M. Bardella’s protestations to the contrary, financial market pricing reflects persistent anxiety that, if in office, pre-election commitments might not be honoured. That the French business community is reportedly rallying around the right reflects concern regarding the even more populist agenda of the left, included within which lies a commitment to lower the retirement age to 60, provide assistance to migrants and asylum-seekers, freeze prices of essential goods and energy, push up civil service pay and increase the minimum wage by 15%. The plan is to pay for this with sharply
increased taxes on wealth, property and inheritance. Whatever the European institutions’ and financial markets’ residual fears regarding the French right might be, they are as nothing compared to those associated with the political left.
IMPACT
The most obvious threat, both to the goals of the European institutions and financial market stability, therefore lies in a potential French Assembly majority for either the political right or the left, and consequent repudiation of the EU’s fiscal rules in favour of a more populist agenda. However, the hope lies in perhaps the most likely scenario, at least judging by opinion polling, that no party is able to form a majority and a fragmented parliament achieves a cobbled-together coalition in which M. Macron’s gamble, the centrist LREM bloc, holds the balance of power. In such a scenario, whilst the French debt/GDP ratio of 112% and general government deficit (the shortfall between government revenue
and spending) at 5.5% remain high by the desired standards of the region’s now implemented ‘Excessive Deficit Procedures’, a slow paced return to more acceptable levels is possible.
In such circumstances, the risk premium now apparent in the French stock market would likely remain high, but perhaps no higher than would likely be the case should a more extreme electoral outcome occur. More importantly, the threat of possible contagion into the financial assets of other countries also deemed in breach of fiscal rules would be less likely. The obvious vulnerability lies in the fact that a loose-knit coalition of widely
Source: Bloomberg
varying philosophical beliefs could break down at any time and a vote of no confidence bring down the fragile administration. The French Constitution precludes M. Macron from dissolving the Assembly for another year (July 2025) and in the event of complete policy paralysis this could put his own position as president at risk.
Pricing in the financial derivatives market confirms that investors have become significantly more worried about potential ‘tail risk’ outcomes (those differing from the best-case scenario). The relationship between the relative pricing of instruments relating to both the euro and the US dollar reflects the non-negligible chance of a destabilising outcome. The Euro Area’s history of periodic crisis reveals a close correlation between bond market pricing and the performance of the common currency. Unsurprisingly, during periods of elevated political risk the euro typically weakens against key pairs, including both sterling and the US dollar. Although the UK election has inevitably dominated domestic media headlines,
the outcome has long been thought to be in little doubt and given only comparatively small differences in projected policy between the leading parties, investors in financial markets have long regarded the UK as a haven of stability over its neighbour. This was recently exemplified by a 10-year benchmark gilt-edged auction which hauled in a record amount of funding for the Treasury.
CONCLUSION – DO ELECTIONS MATTER?
For all the heat that elections generate, the truth is that they seldom make a lot of difference to economic performance over the long-term. In response to the question, do elections matter, their significance from the perspective of the financial markets lies in the potential impact outcomes might have on the always delicate relationship between the bond market and the government. Mr James Carville, political advisor to the administration of President Bill Clinton, once famously noted that if he believed in reincarnation he’d want to come back as the bond market, “That way you can intimidate everybody!”
Expansionary fiscal policies have proved supportive to developed economies during and after the pandemic and in response to higher interest rates. But maintaining fiscal discipline against the backdrop of a heavy debt burden is essentially a game of confidence. If investors believe that a government is capable of pursuing fiscally responsible policies, they will typically try to see past temporary increases in both debt and deficits. But if that confidence is lost, then markets respond immediately, driving asset prices lower and yields sharply higher, increasing borrowing costs and making a country’s fiscal position less sustainable.
This is essentially what is happening in the Euro Area, and more specifically in France. France’s importance lies in the fact that not only is it the Euro Area’s second largest economy, but that it boasts the world’s fourth largest bond market. Instability here risks spilling over elsewhere, a fact not lost on the European
Central Bank which has expanded its ‘tool kit’ to stand in support were disorderly conditions to evolve. It is this ultimate backstop that should encourage investors to keep faith in European financial assets over what could be a testing period in the months to come.
