La Française: 2nd round of legislative elections in France

July 11, 2024

• Risk of paralysis due to a fragmented parliament and a clear lack of a majority
• We remain cautious on French sovereign debt that we underweight
• Risky assets should react more to the macroeconomic environment and the direction of monetary policies than to the results of the French election

The second round of the French general election on Sunday, July 7th, led to a reversal of the trend compared to the result of the first round. The significant drop in the number of three-way contests after the results of the first round of June 30th weakened the Rassemblement National (RN) in favour of the Nouveau Front Populaire (NFP), an alliance of the left between La France Insoumise (LFI), the Socialists (PS), the Communists and the Green Party (EELV).

The National Assembly will be divided into three blocs without an abslute majority

The Nouveau Front Populaire group (182 seats) is closely followed by Ensemble (centrist party of French President Emmanuel Macron and his allies, 168 deputies), ahead of the Rassemblement National (143 seats).

Without an absolute majority, who will govern?

The post legislative period is structured around four stages:

1. negotiations around coalitions,
2. the appointment of the Prime Minister by President Emmanuel Macron, likely paving the way for a period of cohabitation with a Prime Minister who may not necessarily come from his own political party,
3. the formation of the new government (with the crucial choice of the Minister of Economy and Finance), and
4. the functioning of the National Assembly, whose first plenary session is scheduled for July 18th with the election of its new President.

France is therefore expected to experience a period of uncertainty and difficult compromise, with a risk of paralysis, as Emmanuel Macron cannot dissolve the Assembly for another year.

What about the 2025 budget negotiations in the fall, reforms, and necessary cuts in budget expenditures to improve public finances that already concerned investors and rating agencies before the announcement of early legislative elections? On May 31st, S&P Global Ratings downgraded France's long-term credit rating from AA to AA-.

It's worth noting that with a debt-to-GDP ratio of 110%, France's deficit already stands at 5.5% of GDP in 2023, and the country was placed under an excessive deficit procedure by the European Commission on June 19th.

What should we expect on the financial markets?

The Franco-German risk premium measured by the yield spread between French sovereign bonds (OATs) and German bonds (Bunds) at 10 years is expected to remain elevated due to the lack of political clarity and visibility in the coming weeks, along with concerns over the economic pragmatism of La France Insoumise. We are therefore cautious on French sovereign debt, particularly as we have reduced our exposure, especially following the tightening of the OAT-Bund spread to less than 70 basis points on the close of Friday, July 5th, after reaching over 80 basis points on June 28th, a level nearly comparable to that during the French presidential election in 2017.

On risky assets, despite French CAC 40 stocks already underperforming compared to the broader European index since the surprise announcement of the Assembly dissolution on June 9th, the French political climate remains a short-term constraint. We continue to exercise caution while awaiting better entry opportunities. However, given that the revenue exposure of CAC 40 companies to France is limited (around 20%), risky assets are expected to react more to the macroeconomic environment and the direction of monetary policies. These are characterized by anticipated interest rate cuts from the ECB and the Fed in the second half of 2024

i.            Equities

It is still too early to measure the impact of this rebalancing of the National Assembly.

         Caution remains warranted, especially towards sectors most exposed to fiscal risk such as banks and infrastructure.

         The evolution of the OAT/Bund spread remains a crucial risk indicator.

         Volatility is expected to remain high as we await the government's formation.

The PM team had already reduced its exposure to France and does not plan to increase this movement in the immediate future.

ii. Fixed Income

As mentionned before, we now anticipate some stability or even a slight widening in bond risk premiums. The French sovereign risk premium is expected to remain somewhat higher than before the early June elections. Political fragmentation, challenges in controlling the budget deficit, limited room to implement reforms, increased pressure from rating agencies and the European Commission will continue to weigh on French government debt.

Prior to the elections, we had already adopted a defensive stance on sovereign exposures while balancing French risk in our funds through overexposure to credit/private issuers. We believe our risk calibration within our funds remains balanced post-elections.

French banks have experienced significant sell-offs by investors in the wake of tensions over OATs.The impact has been particularly noticeable on subordinated debt, with Société Générale appearing as a favored target among speculators. The banking sector remains the traditional channel of contagion during sovereign crises; however, Q2 earnings reports, which we anticipate will be positive, could alleviate investor concerns.

The high-yield sector has remained relatively immune, but French issuers still carry the heaviest weight in the indices. Recent difficulties faced by groups like Casino or Atos continue to fuel a sense of caution towards the French market. We remain cautious regarding the most heavily indebted French issuers but confident in the stronger ones.

iii. Real Estate

The moment of truth will come in September, when the budget law is scheduled to be voted on. In the absence of consensus, the 2024 budget would be extended, resulting in a deficit well above 3%. In such a scenario, the interest rates on government bonds would come under significant pressure, causing the spread between OATs and Bunds to continue widening. Political uncertainty and measures challenging the return to fiscal balance could potentially lead to a slowdown in economic growth.

For real estate markets, slower economic growth typically correlates with higher vacancy rates, while higher inflation tends to lead to increased rent indexation. The overall effect on rental incomes could therefore be neutral. However, the required risk premium may increase due to heightened volatility components amidst uncertainties. This, coupled with rising government bond yields, could create tension on real estate yield rates.

To capitalize on such a context, the best prospects lie in Core+ and potentially Value-Add investments, which would benefit from a favorable entry point after a period of value correction. Both approaches aim to implement an active management strategy with varying degrees of risk, aimed at creating value. The new cycle ahead is expected to exhibit more volatility, prompting investors to adopt a more active management approach to their real estate portfolios, with shorter holding periods.