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Elections Roundup: In Uncharted Territory
8. Juli 2024
As the year’s busiest election week ends, what could the outcomes mean for investors?
- French election outcome signals worsening fiscal dynamics, potential downgrade
- Rise of Eurosceptic parties in European elections to weaken decision making
- UK confidence to rise as overwhelming majority seen ushering in political stability
High Stakes and Surprising Turns in France
French President Emmanuel Macron’s surprise decision to call parliamentary elections after his party’s European elections debacle has likely resulted in a hung parliament after the second round of legislative elections over the weekend.
With the left-leaning Nouveau Front Populaire (NFP) bloc unexpectedly gaining the most seats in the snap elections, defeating Marine Le Pen’s far-right Rassemblement National (RN) hopes of cornering an absolute majority, the outcome won’t be reassuring for investors worried about the worsening fiscal situation.
The political fragmentation suggests that the fiscal outlook is likely to deteriorate even further. In the run up to the elections, the NFP campaigned on a platform of raising minimum wages and reversing business reforms. On the other side, Jordan Bardella, the 28-year old chief of the RN Party, has held back from committing to bringing France’s deficit back to 3% of GDP by 2027.
While the exact costs of the programmes of the left and right are difficult to gauge, a wider deficit looks inevitable, leading to rising debt and high risk of a ratings downgrade. France overshot its deficit target this year to finish at 5.5% of GDP, among the highest in the eurozone, setting up Paris for a clash with the European Commission on budget rules.
Ratings agencies have already taken a dim view of the worsening fiscal dynamics. S&P downgraded France to “AA-“ in May. Moody’s has already stated that the snap election is a negative risk for the country’s credit rating. There is a growing risk of further rating downgrades if the new government enacts fiscally expansionary policies.
Markets have noticed, and the big fiscal discipline test for the new administration is the annual autumn budget exercise. Meanwhile, the spread French debt pays over Germany has widened and shares in French banks and companies slumped in the days after the election was announced. While early market reaction is muted, asset prices haven’t yet recovered to their pre-snap election announcement levels.
At a broader level, France is weaker after the elections due to the political gridlock and as a result, President Macron’s leadership role in Europe will likely become less effective.
With German Chancellor, Olaf Scholz, also suffering major setbacks in June’s European elections, the powerful “Franco-German engine” of growth and policymaking could lose steam, leaving the space for Eurosceptic parties to set the agenda. For example, the only leader from a larger EU member state who is currently leading with confidence is Georgia Meloni in Italy who belongs to a right-wing anti-establishment party.
French German relations already tense due to fundamental disagreements between Scholz and Macron over EU direction and policies will likely deteriorate further, resulting in weakened support for Ukraine. Geopolitics, already a growing concern for markets in a packed election year globally, will remain on the front burner and relations with the U.S. will likely be more tense.
Regarding monetary policy, while the European Central Bank (ECB) is likely to further cut interest rates twice this year, the bigger picture emerging across the eurozone is growing uncertainty in the fiscal position of countries across the continent.
However, a repeat of the eurozone debt crisis is unlikely, as none of the political parties in France are arguing to leave the eurozone. As a result, bond markets have been well behaved and the selloff in eurozone government bonds orderly.
Though European investment grade and high yield corporate debt spreads are wider since the French elections announcement, value is opening for long term investors based on a backdrop of resilient growth and robust corporate fundamentals, as well as low net corporate issuance.
A Tale of Two Cities
French bonds underperform UK debt on fiscal concerns
Source: Macrobond, PGIM
UK Offers Relative Calm Island
Far removed from the prospects of fiscal slippage or political gridlock across the channel and the growing likelihood of Donald Trump returning as the next U.S. President, Britain seems an unlikely haven of stability.
With the Labour party returning to power with an overwhelming majority after 14 years, some analysts had described the poll as a “non-event” before the vote, with the outcome long expected by markets.
Ahead of the elections, the Labour Party had focused on burnishing its fiscal credentials to distance themselves from the Liz Truss fuelled mini budget debacle in the autumn of 2022, which sent gilt yields spiking higher and plunged the sterling near record lows.
Our view is that in the near term, fiscal policies are likely to have a muted impact on the economy’s prospects. In the absence of formidable fiscal firepower, the Labour Party’s growth plans are premised mainly on a period of calm and predictable economic growth.
The prospect of continuity is providing comfort to investors. Household and business confidence might increase as an overwhelming majority for the Labour Party is seen as ushering in a period of political stability after the country witnessed five Prime Ministers in the last 14 years under Conservative rule.
The Bank of England's trade-weighted sterling index, for example, is close to its highest level since the Brexit referendum in 2016 - almost a quarter up from the mini budget blowout lows. It is a similar picture for the blue-chip FTSE 100 index, which is shy of a record high. In the bond markets, yield spreads between British and German bonds have been contained.
With regards to some key policies, Prime Minister Sir Keir Starmer is broadly on the same page as his predecessor. There is unlikely to be a return to the European common market, though the new government will seek to remove barriers on food and essential commodities with Europe. The UK will also likely maintain a hawkish stance towards Russia, in line with the present government.
In terms of monetary policymaking, we expect three interest rate cuts by the Bank of England starting in August, reflecting the fact that inflation is now back at the 2% target with growing signs of an easing economy.
What do the elections in the UK and France mean for the newly formed European Parliament?
For starters, The Labour Party has ruled out the UK re-joining the EU single market. While senior officials have said London will attempt to deepen UK-EU relations, Brussels has been firm in preventing the UK from reaping the benefits of the single market without the responsibilities. From the EU’s perspective, the prospect of months of political uncertainty in France means the EU will find it difficult to negotiate free trade agreements with third parties.
Perhaps more damaging for the newly formed European Parliament in the long term is the rise of the nationalist parties. The 2024 elections have already thrown up a sizeable shift rightward as we had expected.
Far-right parties had their best-ever European parliament election with major gains in France, Germany and Italy, collectively winning almost a quarter of the chamber’s seats. There is also a growing trend of centre-right parties adopting relatively extreme right-wing postures to avoid haemorrhaging support.
While the right-wing anti-establishment parties might not be able to block the big decisions in Brussels, they could have a louder voice in the day-to-day regulatory decision-making in the European Parliament from areas ranging from migration, common borrowing for defence and green climate policy.
Investment Implications
- In the short term, market reaction will be relatively muted in France as the tail risk of outright wins for the far right and left parties in the elections is averted, though political gridlock will weigh on sentiment. Broadly, eurozone growth remains on trend and the ECB is set to cut interest rates again, an environment conducive for French assets.
- In the longer term, fiscal slippage concerns remain which should also weigh on other indebted eurozone countries. As a result, term premium on French government debt is likely to increase and the euro may face increased headwinds.
- British assets stand to benefit relatively after the election outcome. Coming on the back of the Liz Truss shock less than two years ago, the new administration will be acutely aware of not rocking the fiscal boat, also benefiting the British pound.
Guillermo Felices
Principal, PGIM Fixed Income
Taggart Davis
Vice President, Government Affairs
Mehill Marku
Vice President, PGIM Fixed Income
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