Implications of the French legislative elections

Following a poor showing for his party in the recent European elections, France’s President Emmanuel Macron has called for snap legislative elections. The possibility that Marine Le Pen’s far-right Rassemblement National (RN) party could win the election on a platform of unfunded public spending has unsettled financial markets. French equities and debt both declined last week.

The yield spread between French and German 10-year bonds rose 29 basis points over the week to 77bps, its largest weekly increase since late 2011 during the Eurozone debt crisis. The CAC 40 fell 6% last week, its largest weekly decline since March 2022. At the start of the week, the spread between German and French yields narrowed only slightly to 75bps, while the CAC 40 started the week up 0.4%.

The outcome of the elections is uncertain due to the electoral system's two-round voting process, making it difficult to predict outcomes. The first round on June 30 will likely see 10–15 candidates per constituency, with only those securing over 12.5% of votes advancing to the second round on July 7.

What do we expect?

Based on the latest polls, the probability of no clear majority emerging is high, leading to potential political instability. A first opinion poll, conducted by Harris interactive, suggests RN could secure 235 to 265 seats (a significant increase from their current 89 seats). President Macron’s camp (Ensemble) could win 125 to 155 seats (a decrease from their current 249 seats). The majority in the National Assembly is 289 seats.

Without assigning probabilities, we see four potential scenarios:

• Scenario 1: Rassemblement National (RN) with Absolute Majority. This would allow RN to appoint a prime minister and comfortably pass laws, though internal government dissension could pose challenges. The RN's policies focus on new spending for pensioners and household purchasing power, funded by controlling social spending linked to immigration.
• Scenario 2: RN with Relative Majority. RN could become the largest party but with less than 289 seats, leading to a complex cohabitation, with the president appointing a prime minister from RN. This scenario would likely result in political deadlock and limited policy changes.
• Scenario 3: Front Populaire with Relative Majority. The left-wing coalition could win a relative majority, leading to a similar cohabitation scenario with potential deadlock. Their manifesto includes undoing recent pension and unemployment reforms and increasing spending on pensions and purchasing power.
• Scenario 4: Renaissance 2.0. Macron's party could maintain a relative majority, continuing to face challenges in passing laws without forming alliances. Macron's policies would focus on household purchasing power and competitiveness, partially funded by labor reforms and local authority savings.

Regardless of which scenario comes to pass, we think France's fiscal situation will remain challenging under EU rules, putting serious constraints on any government's fiscal headroom.

What are the investment implications?

Sovereign debt: Political news should continue to affect French government bond yields, especially in medium to longer tenors. Short-dated bonds are unlikely to be much affected by politics and are likely to rather reflect the outlook for the ECB’s interest rate path. France’s credit outlook is deteriorating. Before recent events, we were expecting rating cuts of one notch over the next 12 to 24 months. Higher deficits than currently anticipated could lead to earlier and to more cuts.

In the absence of (unexpected) political chaos, we think risk premiums for French bonds in the run-up to the elections should remain in a fairly contained range of around 20–30bps around the current level of 75 basis points over 10-year German Bunds. The sharp sell-off has triggered some market talk of possible ECB intervention, though Reuters on Sunday reported ECB policymakers were not planning to discuss activating emergency-bond buying mechanisms to support French debt. With the potential for further spread widening into the first round of the elections, we prefer select French corporate bonds rather than government bonds.

Corporate bonds: French corporate bonds are less volatile than government bonds and are not expected to be significantly impacted by the elections. We prefer quality bonds, expecting yields to fall as markets price in a central bank rate-cutting cycle. We see value for investors in select investment grade bonds from multinational companies that are less exposed to national politics and offer attractive yields.

Equities: Policy uncertainty is negative for equities, with higher bond yields and political risk premiums weighing on the market. The CAC 40's underperformance suggests some risks are priced in, but further uncertainty could limit investor appetite. Within French equities, financials, utilities, and infrastructure stocks are most vulnerable to policy changes. There are also implications for the wider European market given one of the positive cases for European equities was linked to potential inflows from foreign investors, who may now be deterred by political uncertainty. We recommend investors use structured strategies to manage risks and explore opportunities in undervalued regions like the UK.

FX: Political uncertainty has been weighing on the euro, but the impact so far has been relatively modest, with macroeconomic data out of the US a more important factor for EURUSD. Amid ongoing uncertainty, we think EURUSD could easily test 1.05 (1.07 currently) or dip below it as speculative accounts are still EUR long versus the USD, and may reduce their positions. Other European currencies may also gain ground against the euro.

In our view, more widespread EUR weakness would require a “Frexit” narrative to develop. But we do not think that the relationship with the European Union and other partners will dramatically change after the election. President Macron would retain constitutional power over Europe, foreign policy, and defense. The RN no longer wants to leave the EU and the Eurozone, instead proposing to limit the free movement of migrants by carrying out national border controls and dialing back EU climate rules.

Overall, the French elections present a complex landscape with significant implications for various asset classes. Investors should avoid overreacting to polls. In addition, we believe political biases can be counterproductive for investment portfolios and that investors should focus on the long term.

For more detail please read our publication Waiting for the day after. Implications of the French legislative electionsPDF of French election watch published on 14 June.