French result supports European spreads but budget concerns remain

After weeks of volatility following President Emmanuel Macron’s decision to call snap parliamentary elections in France, markets were breathing a sigh of cautious relief on Monday after the far-right Rassemblement National (RN) underperformed the polls.

After RN garnered 33% of the vote in winning the first round on June 30, the main worry for markets was that Marine Le Pen’s party could emerge from the second round on July 7 with an absolute majority and an extreme agenda which could have weighed on public finances and European stability.

In the end, while RN did increase their number of seats to 143, they fell well short of the 289 needed for an absolute majority in the lower house after significantly underperforming what polls had predicted. As a result, they are far from being able to form or even play a significant role in a future government.

Instead, it was the left-wing alliance Nouveau Front Populaire (which includes Jean-Luc Mélenchon’s far-left La France Insoumise group) which took a surprise victory with 182 seats, followed by President Macron’s centrist alliance which also did better than expected with 168 seats.

With no party or coalition gaining a majority, President Macron will now need to appoint a prime minister who can get enough support in the lower house. This will be easier said than done given how far apart the rival coalitions’ agendas seem to be. There is already some infighting within the left-wing alliance, with the most extreme party La France Insoumise claiming they should be given the post, and the leader of another part of the alliance, Les Ecologistes, inevitably rejecting this idea and insisting the prime minister will need broader support.

For now, from a markets perspective the worst-case scenario of an RN absolute majority has been avoided, and with a hung parliament it is very unlikely that any of more extreme parties will be able to gain enough support to advance their agendas. A drop in the spread between French and German government bonds to around 63bp on Monday morning was evidence of a relief rally.

However, the result does little to address legitimate concerns around the French public finances. While it is hard to judge at present, France will most likely end up with a broad coalition tilted toward the left side of the spectrum. While a broad coalition keeps the more extreme parties on the fringes, it also means an effective stalemate with no meaningful legislation being able to get parliamentary support for the next three years. While there are examples in other countries of this scenario being benign for markets, we have to acknowledge that France’s budget is already in the red and expected to continue in this condition in the coming years.

A left-leaning coalition in parliament would not help improve the budget deficit situation. For a prime minister to be palatable to the new parliament, it is almost a certainty that Macron will have to compromise in some way with the left. It is difficult to see how this would not imply more fiscal loosening given the left’s policy agenda and the fact they were the largest coalition after the election.

We expect risk sentiment to remain fragile towards French assets while the process of nominating a new prime minister is ongoing, and we don’t see French-German sovereign spreads dropping back to pre-election levels given the fiscal uncertainty.

Having said that, French assets have already underperformed and the risk of extreme outcomes from the election is lower now. Wider ramifications for European unity and stability should also be contained. From a fixed income point of view, this should be supportive for European spreads at the margin.