France: Cautious optimism
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Article Type
Market Updates
Topic
Opinion
Published
November 08, 2024
Read time
5 mins
Author
Luca Ferramosca, CFA
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Market attention rapidly switched to the other shore of the Atlantic as a historically tight US presidential race culminated in President Trump securing a second term. This comes after months of repeated attempts by the market to confront French prime minister Michel Barnier’s new government and minority centrist-conservative coalition and test its ability to overturn the fiscal mess bequeathed by Emmanuel Macron and his ministries. Recent idiosyncratic political and fiscal headlines have failed to rattle the European government bond market in a sign that investors’ positioning already reflected the significant deal of negativity priced in the 10-yr French OATs vs Bunds.

 

Barnier last month unveiled a €60 billion fiscal package to curb the ballooning deficits, which includes €49 billion of spending cuts and €20 billion of increased revenues, largely through tax increases targeting corporations and high-income individuals. Belt-tightening measures, aimed at reversing seven years of business-friendly reforms enforced by Macron, did not resonate well across sectors such as luxury, defense and construction. The public deficit is projected to peak at 6.1% of GDP this year, with the expectation of a gradual decline to 5% by the end of 2025. In the meantime, lawmakers are still debating the proposal and the advanced pledges may undergo significant changes before being enacted. In fact, the far-right party Rassemblement National (RN) ruled out strategically voting in favor of the budget to secure some concessions. As a result, Barnier will likely scale down his initial consolidation plans to clear the path for tacit support via abstention from RN.

Budget Deficit as % of GDP

 

Budget Deficit as % of GDP

Source: Aegon Asset Management, Bloomberg. As at June 2024.  

 

Despite the “temporary” connotation that Barnier has attached to these measures, the precarious current state of French coffers, paired with relatively bleak growth projections, could soon render these measures permanent. This has the potential to further put a dent into investors’ sentiment and damage the pro-business climate instilled during Macron’s administration.

 

The long-anticipated and much-feared reaction by rating houses has come squarely in line with the market’s consensus and consequential knee-jerk moves were broadly averted. As widely expected, Fitch and Moody’s both moved France's outlook to negative and affirmed its current rating (Aa2 and AA- respectively). This decision scores a higher degree of confidence for the bulk of benchmark-restricted investors and prevents any supposedly significant flows that would have resulted from a downgrade. We don’t expect any downgrade action from S&P which is set to review France’s sovereign debt of AA- in late November 2024.

 

Barring any renewed short-term anxiety about the country’s degraded public finances, current pricing leaves OATs on the cheaper end of the range, qualifying them as a candidate for carry positions once US election-related volatility subsides. An important technical consideration to be made for OATs is the firm and structural demand domestic institutional investors bring to the market. Admittedly, flows from players such as French insurance companies are highly predictive as their sensitivity to the yield levels naturally act as a support to the outright level of longer-term tenors. Volumes from international investors remain elevated and also contribute to fixing a mechanic ceiling to the level of OAT-Bund spread. This indirectly spares the country’s debt to the mercy of “bond vigilantes” driven price action.  Earlier last month, the Agence France Tresor (AFT) published its funding program which was revised to account for the additional fiscal slippage. OAT issuance was left unchanged and T-bills absorbed the entire additional borrowing needs, resulting in a roughly neutral impact on current OAT valuations.

 

A more academic metric, used by pundits to gauge sovereign credit risk, is the redenomination risk as measured by the CDS ISDA basis1. This is simply the spread between the quoted ISDA 2003 and 2014 CDS of a specific country’s sovereign debt. From a historical perspective, current levels of the CDS ISDA basis are nowhere near those seen in countries such as Italy thus displacing any uncorroborated fear of further significant sell-off.

 

Redenomination Risk France vs Italy

 

Redenomination Risk France vs Italy

Source: Aegon Asset Management, Bloomberg. As at 11/07/2024.

 

On a flurry of more credible fiscal tightening measures and encouraging growth outlook, we remain constructive on France’s sovereign risk with a preference to be neutrally positioned until political noise dissipates and eventually takes a back seat. We favor a cautious approach to guard against any potential risk-off sentiment stemming from the reassessment of the implications for a Trump’s presidency and the prospect of a full-scale cutting cycle dictated by an overall continuation of the disinflationary trend and faster-than-expected weakening of the eurozone economy. From a technical perspective, the removal of the ECB’s multi-year asset purchase program across the European Government Bond space may exert some pressure on heavy issuance countries such as France. At the current valuation, we believe the OAT-Bund spread screens are relatively attractive and offer good compensation for unit of risk while on a longer-term horizon we remain cautious on the fiscal consolidation path.

 

1Since the eurozone crisis there has been a significant change in how the CDS market operates. The ISDA 2014 definitions were introduced, and the resulting bifurcation in activity on sovereigns (as well as banks) means that spreads are quoted on both 2003 and 2014 definitions. The basis between the two spreads - often referred to as the ISDA basis - provides valuable market-derived information on the risk of a country leaving the eurozone. Some refer to this as the redenomination basis. (Source: https://www.spglobal.com/marketintelligence/en/mi/research-analysis/cds-redenomination.html)

Disclosures

Author

Luca Ferramosca
Portfolio Manager

Luca Ferramosca, CFA, is a portfolio manager with a focus on sovereigns. Prior to his current role, he worked as an institutional sales analyst at Aegon AM. 

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