France – Summer déjà vu

What happened?

French assets have been roiling recently with French 10Y bond (OAT) spreads to German 10Y (Bunds) climbing to their highest level since January at 82bps. French 10Y bonds now yield only 6.7bps less than their Italian counterparts, their lowest level since 2005. Spreads on French credit default swaps have jumped from 33.6bps to 37.6bps since last Friday. The equity benchmark CAC 40 had lost 3.26% as of Tuesday before paring back some of the losses to a current week-to-date loss of 1.97%. Banks have taken the hardest hit with a loss of -8.8% by yesterday's close. The financial market movements are largely a reflection of the increase in political uncertainty that has been building over time in the background. After months of disputes, the government of François Bayrou managed to pass the 2025 austerity budget through parliament and is delivering the promised savings. Throughout the summer, Bayrou repeatedly emphasised that France must make massive spending cuts. 

Unusually early the prime minister presented the key points of next year’s budget back in July. It includes savings of around EUR44bn. Otherwise, acute over-indebtedness threatens to render the country, economically and politically, incapable of action. This year, interest payments will become the largest item in the budget, Bayrou stressed. He also proposed abolishing May 8 (Victory Day) and Easter Monday as public holidays. However, the budget plans are facing resistance — not only politically, but also from civil society. For weeks, a movement called Bloquons Tout (in English: Block Everything) has been forming, aiming to paralyze the country on September 10. Bayrou has chosen his own departure date, according to the far-left party LFI, which has called for a general strike.

La France Insoumise (LFI) parliamentary leader Mathilde Panot emphasised that the party would certainly not express confidence in the government. The Greens and Communists who along with LFI form the so-called New Popular Front, the left-wing alliance in parliament, have also announced they will not support Bayrou in the confidence vote. The far-right Rassemblement National (RN) plans to do the same. RN parliamentary spokesperson Thomas Ménagé stated that supporting this government would be a betrayal of the voters. This puts the Socialists in a difficult position. They must choose between ensuring the political survival of an unpopular government and deepening divisions within the left or joining forces with the far right to bring down Bayrou — thus exposing the country to major challenges. Socialist Party leader Olivier Faure left little doubt about his party’s intentions not to express confidence in Bayrou.

Instead, the party plans to present its “counterbudget” over the next days. Bayrou knows the uphill task he faces but has nevertheless opted for a confidence vote. He has presented a budget that is apparently attracting little support from the parliamentary opposition, the unions or the general public. Although the government is receiving backing from Gabriel Attal, parliamentary leader of President Macron’s Renaissance party, the responsibility now lies with the members of Parliament, who will vote on September 8. If Bayrou and his government fall, the question arises: who can still govern France with the current composition of Parliament? And will President Macron dissolve the National Assembly once again given that the constitutional restriction that at least one year must have elapsed between the previous parliamentary elections and the dissolution no longer applies? There is also a bigger issue at play, that by toppling government after government, both parties aim to pressure the President into resigning and force early presidential elections. 

What does it mean for investors?

From an economic perspective, the government's aim to reduce the deficit to 4.6% by 2026 appears increasingly optimistic. To prevent further expansion of the deficit, France must identify annual savings equivalent to approximately 0.5% of GDP. Although the current absence of fiscal austerity measures may bolster shortterm growth, it simultaneously contributes to a rising debt burden, which conflicts with EU fiscal requirements. This situation is reflected in rising French OAT yields, which account for both fiscal dynamics and prevailing political uncertainty. Considering the broad spectrum of possible scenarios outlined above, we do not anticipate a significant narrowing of the OAT-Bund spread soon. Bond investors are not only concerned with the prevailing political instability but are also attentive to the upcoming review by the rating agency Fitch scheduled for September 12, just four days after the parliamentary vote.

Subsequent reviews by other rating agencies will follow, with Moody’s on October 24 and Standard & Poor’s on November 28. France currently maintains an AA- sovereign rating from Fitch; however, the ongoing political uncertainty introduces additional risk to this rating. Should two of the three major agencies implement a downgrade, it may limit banks' ability to use OATs as collateral, thereby reducing an essential source of demand for French sovereign bonds. Since one-third of all maturing French government bonds (OATs) are held by the ECB – which is in the process of decreasing its bond holdings – OATs are becoming increasingly reliant on alternative sources of demand.

A downgrade may also lead to increased costs for CDS protection as the market responds to heightened perceptions of default risk. Furthermore, with Italy scheduled for a ratings review on September 19, the outlook for OATs remains uncertain. In this scenario, the spread between OATs and Bunds could widen further. Should France experience a downgrade while Italy receives an upgrade, it is possible that additional capital may flow into Italian bond markets at the expense of French bonds. From a foreign exchange perspective, barring significant changes in the political environment, the EUR is expected to experience limited impact. Current market conditions have already incorporated considerable risk premium, as evidenced by the OAT-Bund spread, and have taken into account the previously mentioned downgrades.
Regarding potential deterioration of the situation, France faces two primary scenarios: the appointment of a new prime minister backed by the existing parties, or, should elections be held, the emergence of another fragmented parliament – both outcomes would largely mirror the status quo. Provided that France refrains from materially increasing its debt levels and continues efforts toward fiscal consolidation, even if it does so at a somewhat slower pace, currency markets are unlikely to factor in a notable additional risk premium for the EUR. On the equity front, the initial decline in the CAC 40 that we saw this time around was about half the size of last summer's drop following snap election news, when the index lagged the broader European market by 4ppts for two weeks before stabilising. French stocks may continue to underperform in the short term. We do not expect weakness to spill over to the broader European stock market.

We highlight that the CAC 40 has underperformed the broad European market by around 5ppts year-to-date, driven by weaker relative earnings dynamics. Nevertheless, the index is trading at an NTM P/E ratio of 14.7x, which is 7% higher than the 10Y average. Furthermore, compared to the STOXX Europe 600 the index’s valuation is close to its 10Y-high. This week, banking and insurance equities experienced the most pronounced declines across sectors. Several factors contributed to this trend. Firstly, rising OAT yields have led to losses on sovereign holdings, as OATs comprise 12–30% of bank portfolios; nonetheless, these exposures are typically hedged, which mitigates the negative impact.