In the year of elections, two of Europe's three largest economies are heading to the polls, and investor's reactions couldn't be any more different.
France's upcoming parliamentary elections are wreaking havoc on French stocks and bonds, while UK financial markets have been relatively stable as the country gears up for its own general election on July 4th.
So what are the markets telling us about the political landscape and are there risks that are being mispriced?
I think the problem with this and the reason that markets are funny at so difficult to price is that there's not a clear path to a great outcome for markets.
I'm Al Senethen and this is Goldman Sachs' exchanges.
For today's episode, I'm sitting down with my colleagues in Goldman Sachs research.
Sharon Bell is a senior strategist on the European portfolio strategy team and George Cole is the head of European rate strategy in the global macro and markets research group.
They're both joining me remotely from London.
Sharon, George, welcome back to the program.
Great to see you all. Thank you.
Thanks very much. So let's start with the French elections.
The snap election called by French President Emmanuel Macron, which will take place on June 30th with a second round on July 7th, was no doubt a surprise and I'm not saying it wasn't, but it sent French assets into an absolute tailspin.
Sharon, why do the markets react so strongly?
You know, I think that there are lots of reasons.
I mean, I probably put them down into four different buckets.
One is the first one which you've already covered, which was a surprise.
We've had lots of elections this year, but this one wasn't expected.
First of all, secondly, the outcome of this election looks quite uncertain and markets hate uncertain.
So I think that's important as well.
But probably thirdly and most importantly, the debt situation in France is pretty worrisome and debt GDP ratio of over 110 percent and quite a large deficit as well.
And the concern is that you will see more fiscal slippage.
You will not get a so coordinated government that will bring that deficit and debt level down over time.
So that's a big concern.
And then finally, with my equity hat on, I would say that some of the policies, particularly the far left and the far right parties in France, would hit company earnings, discussions of things like say potential windfall taxes, for example.
So there are lots of reasons and really though the market hates uncertainty.
And is there an election outcome that the markets are most concerned about?
I think the problem with this and the reason markets are funny at so difficult price is that there's not a clear path to a great outcome for markets.
The one that they would like most of all, I believe, is the status quo we've currently got.
The current sort of government is planning to reduce the deficit in France and we did have eventually debt GDP in France picking coming down.
The other potential outcomes that we might get, for example, a minority far right government or a majority far right government, either of those are much less likely to bring down that debt ratio in France.
So there isn't really an outcome that markets are looking at that says, yeah, this is much better than we expected.
And I think even the outcome that we do get over the next few weeks, if it's a minority government or no coalition is formed, you might have further elections only a few months away.
So again, that adds an extra layer of uncertainty for markets in the volatility that we've had through so far which assets have moved the most.
So if I look, I mean again, I'm going to focus on equities here and George can talk a bit more about rates.
But if I look at the French equity market overall, the gains that we saw this year were wiped out really in very little time.
And we've seen double digit falls for things like the French smoke cap indices domestic stocks in France banks and we've also seen shuffles of infrastructure companies which tend to be quite defensive stocks in France too.
I mean European equities they have had a bit of a setback and particularly relative to the S&P.
So if I look relative to the S&P 500, the stocks 600 which is a broad measure of the European market, that's down 5% relative to the US market in the last couple of weeks.
The impact on global equities though has been quite tiny.
So I do think this is seen as more a French issue first and then a European issue second.
Well, as you said though, the European equities have been hit a bit.
Do you think the markets broadly are overreacting when you think about the moves you've seen in European equities and then even in French equities?
Yep, it's a good question given that the moves that we've had for the CAC 40 companies which is the blue tip index in France, the actual exposure to France in terms of sales for those stocks is quite small.
It's about 15% of their sales exposure.
I sometimes think it works better to flip it the other way around and think that 85% of these companies' exposures is outside of France itself.
So arguably the moves which we've seen year to date wiping out the progress that the CAC 40 had made does seem quite harsh relative to the fact this is a very international index.
But that being said, I do think the uncertainty is extremely high, investors are nervous and the CAC 40 had been a good performer in recent years with a relatively higher valuation.
So given all of that, I don't think the market move is all that extreme.
I think there's been pockets that might have been a bit extreme relative to say direct earnings impact, but given the sort of higher risk premium that we now have, I'm not surprised to see this type of move.
Interesting. Enjorge, if you look at the bond market, French tenure government bond yields have surged relative to German bonds to the wider levels we've seen in recent years.
So what are the markets, the bond markets telling us about this situation?
We do know that the European bond markets price in relative creditworthiness via these credit spreads.
So the level of yields typically benchmarked against the strongest credit Germany.
I'll give you some sense about the market's concern about the ability to finance future debt, confidence in future fiscal trajectories and so on.
And they move around with the fundamentals.
So if growth is weaker or a government plans to spend more, you typically find these credit spreads widening.
Now what we've seen is about a 30 basis point, maybe depending on the day, maybe slightly more credit spread widening between France and Germany.
That sounds maybe small relative to the sort of credit spread widening we've seen in other European markets over the several years.
But this really is quite a big move for France.
It's akin to the move we saw ahead of the 2017 French presidential election, which again was a fairly notable widening.
And so what it is really telling us is that the market is concerned that ultimately, either because of a general rise in the level of uncertainty about any future government's capacity to improve the fiscal path or the possibility of electoral outcomes where you have significant spending that is on top of the current fiscal trajectory, which as Sharon mentioned
is already a source of some concern for markets.
That really has left us in a fairly net negative position.
We either learn that spreads probably struggle to recover the levels we saw before the European election, simply because the outcome worsens for the French president Macron, even in perhaps a situation of a hung parliament, for example, if you had a diminished relative majority, or we learn that actually a government comes in with a more expansionary fiscal
program. And so the market is wrestling with that risk.
It's also interesting to note we've seen a bid for German bonds.
And so it's not just been a rise in French yields.
What we've also seen is that spread has widened because German yields have fallen.
And although French yields have been creeping back up that actually tempers the overall yield move for French bonds because ultimately the credit spread can widen not only because French yields go up, but German yields go down and so actually insulate the overall level of yields in France.
And George, you said that there's actually a bid for German bonds, flight to safety, I assume.
Are there other assets that are particularly vulnerable or going to benefit in the bond market?
Yeah, well, I think that this is really the key thing that we're looking out for is the extent to which stresses or repricing of credit spreads in France spills over into other markets.
We've seen in previous episodes, of course, you know, generalized spread moves in Europe, for example, think about Italy and Spain and Portugal.
When you see, you know, a weakening of credit spread in one market, you often find that there are spill overs to the other markets.
And so that is a key thing that the market is, you know, really got it iron.
The world does look a little bit different to where we were perhaps a decade or so ago.
We now have additional measures, for example, at the ECB or the EU wide level that reduce tail risk, the ECB has its transmission protection instrument, which is a kind of backstop facility to buy bonds if stress is emerged.
We know that at the EU level, there are additional fiscal pooling measures through the recovery fund that supports other European economies.
And so in that sense, we perhaps don't have the same vulnerabilities as in the past.
However, we do have a situation where if there is a substantial challenge to, you know, fiscal discipline coming out of the next French government, there is maybe the potential for that to have knock on effects to other economies.
So what we are noticing is that although we are looking at the move in French bonds as probably being reasonably large given the potential for the next government to undertake an expansionary fiscal plan, it does look like the market is still quite calm about the implications for other economies.
It's not clear that that is wrong, but it's also something that makes us a little bit wary about stepping in, for example, to buy these other markets just here.
Right. So it's not clear that the market is right.
I think what I'm hearing you say, but if we take a step back for a moment, I recall heading into this year, there was so much focus on how expensive the US market had gotten after a period of US exceptionalism for several years and growing optimism that the investment flows into the US would start to redirect towards areas elsewhere, such as Europe.
How's this ongoing political uncertainty in a core member like France upended that narrative?
Yeah, this is a great question and a real problem for Europe.
If we do about the clock a bad month ago, I think the main conversation I was having with global investors was the concern that, although yes, absolutely, the US has got its exceptionalism, you're already well pricing that in the case of the US.
So the S&P was very expensive and the Mag 7 in the US are such a dominant part of the index.
You're very concentrated in your exposure if you're investing in the US.
So there was a kind of view that, well, maybe we should look at Europe and they looked at Europe and they found that activity was improving, interest rates were coming down in front of the Fed, very helpful and that valuations were a lot lower.
And although the European equity market is quite concentrated too, it's not as concentrated as in the US and not in just that one sector either.
So, you know, tick, tick, tick, you felt that Europe offered some value and some cyclical improvement.
I still think it does, but I think this is obviously added to uncertainty.
And really, if I look at investment flows in Europe in the last two years, we have had constant outflows from global investors into Europe.
And really, ever since Russia invaded Ukraine, we've seen those consistent outflows.
And they were starting to come back in, as I said in the month ago.
Also, you were starting to see investors interest in Europe for those elements I mentioned before.
But this really has shown a lighter, I would say, on the structural problems Europe has.
So the structural problems were always there, but you were willing to overlook them for the cyclical upside I just mentioned.
The structural problems being a lack of growth, lack of productivity, lack of investment, all of that I would put under the label of lack of growth.
And then the debt level that's already accumulated in Europe.
So those two problems, and I think those structural issues, which are very difficult to resolve, this for intellectuals, really, Shona Lighton, those particular problematic issues.
And if we do see the outcome that the market fears, a far-rate majority taking hold of the government, and we see the fiscal expansion that the market is concerned about, that's ultimately inflationary, in which case will that complicate the monetary policy mission going forward?
Yeah, so I think this is the really interesting issue for the European economies.
It can be very challenging to undertake a unilateral fiscal expansion that actually does have the impact on growth and inflation that you want.
That you want this to be better for growth.
The reason is that credit spread, because if that credit spread wideens enough, then actually this is detrimental to growth.
We've got a situation where the market is worried about fiscal risks, and the net impact for the economy may not be positive.
It may be that ultimately credit spreads or absolute yield levels rise so much that actually it has a contractionary effect on the economy.
Again, that may be not quite where we are, however, that I think is the really important thing to remember.
The growth benefits from looser fiscal policy can be taken back by that widening in the credit spread.
That's why I think ultimately the ECB will be very, very focused on transmission, because ultimately you're right, inflation is too high, if you would see, for example, a cooperative coordinated fiscal expansion at the EU level or the area wide level, that would be much more inflationary.
But if you saw one country unilaterally attempting to undertake a big fiscal expansion, that actually could have the opposite effect if the financial conditions tightening via wider spreads, undoes the impact of that better growth.
I think it's a little more complicated than to say the impact would be net inflationary, because ultimately the market will give you a signal about, whether or not that fiscal policy is tenable.
I think for that reason, it does suggest that the incentive for any incoming government, even the absolute majority of national rally, would be to moderate the fiscal program compared to a situation that would see a very significant and negative market reaction.
But again, the market obviously has widened because it just doesn't know what is likely to come next.
I think that's such a good point as well, because we've had some incarnations of populist governments in the last few years that didn't turn out to be as negative for markets as perhaps investors feared beforehand.
And of course, that is an upside risk here that you do see a majority or even a minority government, which is national rally, and yet they're perhaps not as extreme in their policies as many investors worry about.
Interesting. Let's turn to the UK election on July 4th, where the outcome seems potentially more certain and markets have reacted less strongly.
Sharon, what is she's already there?
Yeah. So for equities, the UK election, I would say, is less worrisome.
And I think less worrisome than what we've been talking about with respect to France in two senses.
First of all, the polling date is pointing to a clear lead for the Labour Party.
So the outcome feels a lot less uncertain.
And the second is that the space for being radical on policy is much more limited as both of the main parties in the UK, the current government under the Conservative Party, or the Labour Party that is in the lead in the polls, both of them are promising to keep within quite tight fiscal rules.
And given that, there isn't a lot of space for huge surprises of the nature that will potentially spook the markets.
So I see it as much less of a risk event.
George, do you agree? Yeah, I mean, I think that when we look at the macro implications for the various plausible outcomes under the current party plans, we really don't get a particularly widespread on things like growth inflation, the deficit.
It's not as if there are no differences.
And perhaps you could imagine the market thinking and trying to price and understand, for example, differences in the composition of the deficit.
Is it more taxation, more spending, or is it less on both?
Is the margin of the governing majority going to have some impact on the way that the market reacts?
All of that is possible, but I think that's kind of second order to the point that Sharon made that ultimately it feels like the overall uncertainty around this election, not just for the outcome itself, but the implications for macroeconomic policy on the far side is likely to be a bit smaller this time.
But it always seems like as soon as we get comfortable about the amount of uncertainty and assume something will be more certain, we're surprised.
And political uncertainty has, of course, been a key feature of the UK.
I'm thinking back to the 2022 LDI crisis Brexit.
Still, maybe that was a moment where we expected some volatility and tremendous amount of uncertainty, yet it was still somewhat of a shocker.
So are there any risks in the UK that are being mispriced or underestimated, George?
That's a really good question.
And I think that you're absolutely right in listing the events of the recent decade and looking at the levels of uncertainty with a market pricing, in terms of volatility priced into markets, looking at the big shifts in asset pricing that we have seen.
Of course, that uncertainty has had huge impacts on UK markets, on sterling and on the real economy itself.
I think in some sense, the freshness of the 2022 LDI crisis means I am more confident to say that those risks have diminished simply because I do think again, just having that in the recent history itself constrains the kind of political possibilities in a way, because the costs of that event were just so significant that ultimately, it does push toward more moderate
policies. And I think has really made it clear that taking excessive fiscal risks is quite an unwise thing to do again in the current moment when yields a high inflation is high, the central banks, you know, are finding it difficult to provide a lot of relief by cutting rates.
And so it's not to say, of course, that fiscal risks have disappeared.
They are still, of course, there for the UK, but it does look like at least in terms of the political consensus, it's moved to a much more moderate position.
Maybe I could mention one other thing, which is that we've very clearly seen the UK move to a relatively hard form of Brexit, introducing a lot of friction with the trading relationship with Europe.
I think it's interesting to consider the possibility that maybe that doesn't worsen from here, and in fact, may even improve.
And so in a sense, could it be that the risk that is mispriced could be a positive one?
I mean, that seems something that might seem a long shot and probably is a more long-term question for the UK given the current political reality.
But I think that the situation where the UK seeks to improve what has been a really poor productivity performance by loosening the supply side of the economy moving closer to its newest trading partner, not reversing Brexit necessarily, but maybe taking measures to reduce trade frictions or inter-intervary reciprocal agreements.
And I would argue with inequities that sort of upside risk, upside potential, is not super priced either.
If I look at say FTSE 100, the big cap index in the UK, it trades on roughly half the valuation of the S&P, and many would argue, right, so because it doesn't have the exposure to tech, but it is one of the cheapest indices globally.
And if I look at say the FTSE 250, which is the big cap index, which is much more UK exposed, that is also trading on a similar valuation, and it's close to the lows of its valuation range in the last 20 years.
So this shows you the market's already pricing a lot of the weaker structural problems in the UK, and not so much of the potential upside risk that George talked about.
But it seems kind of ironic to me that just as the UK may be getting to a place where it could start to strengthen its relationship with the Euro area again.
The Euro area again seems to be very much in question.
Correct me if I'm wrong, but I'm hearing more and more concerned about the fragmentation of the Euro area than I've heard in quite some time.
So as a leaving question, let me just ask you, what are you watching in terms of the signs of going west in the Euro area?
So very clearly, as I mentioned before, watching the credit spreads, there is a very clear way to see is the market pricing this as a localized domestic issue for France, or is it broadening out and seeing spillovers into other sovereign markets and being priced as a more generalized, if you like, systemic risk in Europe?
It's a reasonable question to ask, how can France have a serious issue, for example, around fiscal policy or credit spreads without it being a European issue, just given how important France is to the broader Euro area and EU as a whole.
And I think that that is a perfectly reasonable point to make.
And so in a sense, I do think watching this relatively calm response that we've seen in other sovereign bond markets is absolutely key.
To the extent that that begins to broaden out, it would be a sign that maybe the market is starting to connect the dots and say that whether it's because of potential changes to fiscal rules, whether it's because of potential implications for the 2027 presidential election in France, there might be broader risks than just something you see on the French domestic
political front. And then of course, I do think for the broader economy, is this something that will be a negative for French growth?
Will it be broader tightening and financial conditions that will weaken the economy because what we do know is that Euro area fragmentation risk, as you mentioned, we have seen that that really comes to the fore when growth is particularly weak.
And at the moment, what we have seen is that there has been some signs of a cyclical upswing.
We know that the European consumer will benefit from lower inflation, lower energy prices.
That should be a tailwind to growth.
But if you were to see a financial conditions tightening, short circuit that and move the Euro area into a weaker period of growth, that of course increases those risks.
I would say that again, and I think I mentioned earlier, the world is different post pandemic.
We do have additional backstops in the Euro area that could tail some of the fragmentation risk that we've seen in the past.
Again, that might be one of the reasons why the market is a little more relaxed at this time beyond the French bond market.
But that of course bears close watching.
And I think what is clear is that we certainly haven't seen moves in sovereign bond markets that would warrant some intervention with those backstops from the ECB that of course would be a lot further away in terms of spread widening.
So watch the outcome of the French election, of course, watch for any spillover risk into other regional bond markets and the economy more broadly.
And in the UK, let's see, let's see for another political surprise or if we and the markets are right that we're going to have a more benign outcome and hopefully a bit more of a positive trajectory in terms of the relationship between the UK and Europe.
And we'll see what it brings for the economy markets.
Absolutely. I think one thing I would say is just, you know, we're four for four for interesting elections so far.
If you think across emerging markets, the EU election, which again, threw up the surprise of the French.
And of course, we've got some big ones to come.
Sharon, George, thanks so much for joining us.
That's great. Thank you.
Thanks very much. This episode of Goldman Sachs' exchanges was recorded on Thursday, June 20th, 2024.
I'm your host, Alison Nathan.
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