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Before the announcement of snap elections, France's financial situation was exceedingly precarious. In 2023, the country posted the largest primary public deficit in the Eurozone, amounting to 3.8 percent of GDP. Despite the French government already canceling 10 billion euros in spending, it was seeking ways to save an additional 20 billion euros next year to avoid the European Commission's «Excessive Deficit Procedure».

Nevertheless, investors continued to show full confidence in the country, as reflected by the very stable OAT-Bund spread of 47 bp just before the elections. Credit rating agencies, as well as the European and international institutions, had accepted that the public deficit could deepen temporarily, to account for the structural reforms put forward by Emmanuel Macron – as the economic growth these would foster could also generate additional tax revenues.

France’s delay in lowering its deficit was becoming worrisome, but not insurmountable, insofar as the French Government continued to tighten public spending.

«Whatever the outcome of the elections, the French deficit is less likely to be reduced, unless…»

The decision to dissolve Parliament has reshuffled the cards: indeed, within the three blocks (Nouveau Front Populaire; Ensemble; Rassemblement National, RN), the only group supporting a strict budgetary policy has just been disavowed in the elections. The political agendas put forward by the other two blocks will only deepen the public deficit further, though to varying degrees.

While the RN has suddenly tempered its ambitions, now advocating for an audit of the nation’s finances before rolling out its agenda, it remains evident that even in an optimal scenario where the party secures a majority, the likelihood of reducing the deficit is virtually non-existent. The prevailing narrative emphasizes addressing social demands that, according to the RN, were ignored by the previous administration.

At this point, if we were to freeze the situation as it stands today, two likely scenarios would emerge: the first is failure to achieve a majority in Parliament, leading to the appointment of a technical government and new elections to be held one year down the road; the second is the RN winning a majority.

Whatever the outcome, France is about to turn its back to structural reforms and lower its deficit, meaning Brussels could launch a procedure this summer. However, nothing indicates that the current reshuffling of the political landscape, both left and right, will be set in stone after the elections.

«To what extent could the ECB intervene in the event of the crisis?»

There is a third scenario, assuming that in the absence of a majority and with continued political reshuffling after the elections – just as impossible today as possible in a few weeks – an alliance is formed between strands of the political spectrum known as «government-ready» (from the center, right and left) that would create a new majority, supporting a sounder economic agenda.

The widening OAT-Bund spread since the election, at around 30 points at the time of writing, remains marginal. It would require a much larger movement – though this remains unquantified – to raise the issue of potential ECB support and the introduction of a TPI. The fact that France could trigger the EU's excessive deficit procedure would be an undeniable hurdle for the ECB, though not prohibitive.

Furthermore, the ECB cannot be insensitive to the German political context, with the poor results of the ruling coalition and the more conservative rhetoric voiced by the right-wing party, threatened further on the right by the fast-rising AFD – which is considering a referendum on a DEXIT if the party wins the next general election next year.

The central bank retains some degree of maneuverability, but this should not be overestimated given the increasingly fragmented and divided European political landscape.

«The question here is whether France will be able to reach a new deal with Brussels»

Any forecasts of a financial crisis in France and Europe would be hazardous at this stage. For the past week, a European risk premium has been building up. If the next French government implements a stimulus-based agenda – which seems rather unlikely but possible – it will undoubtedly encounter upheavals similar to those experienced by the Liz Truss government.

If it simply ‹puts on hold› the lowering of public deficits, the crisis may be narrowly avoided, but sovereign spreads will continue to fluctuate nervously depending on how European authorities and credit rating agencies respond (the latter will downgrade the country as they were hoping for public spending cuts).

The question here is whether France will be able to reach a new deal with Brussels, or if a show of strength is about to begin.

«Within our asset allocation, we have lowered risks»

On the other hand, a majority in Parliament would enable France to continue working towards its European commitments, and the European risk premium would largely subside.

Within our asset allocation, we have lowered risks. First on European equities, following the announcement of the snap election, and later on US equities to take some profits and revert to a neutral exposure to risk assets. We believe that the relative strength of the economic environment and the continued – though admittedly a little chaotic – disinflation process should enable risk assets to deliver decent returns.

Unless the French imbroglio turns into a full-blown European crisis. And accounting for the fact that the US elections are just a few months away and that markets will become increasingly sensitive to survey results and Donald Trump’s potential return to the White House.

Benjamin Melman is the Global Chief Investment Officer at Edmond de Rothschild Asset Management.

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