European markets have been volatile, with increased political risk being priced in as far-right parties gained representation in France, Germany and Italy in the European parliamentary elections last weekend. President Emmanuel Macron reacted to his party’s low score in the European vote by calling a snap election. While the timing surprised, the decision comes as Macron’s government had been lacking a parliamentary majority since 2022 and the alternative would have likely been three years of a lame-duck presidency.

JHI

JHI

European elections have typically been where the protest vote is expressed most strongly, while the legislative election has historically favoured more traditional parties. However, the far right is now more mainstream, in our view, than it has ever been in France. Below are the some of the potential scenarios that could potentially play out:

• A National Rally absolute parliamentary majority – Macron would effectively be forced to appoint a National Rally prime minister, likely Jordan Bardella, who has been designated by his party for the role. With a majority under him, Bardella would in theory be able to decide on many topics such as pensions, employment, education, tax, immigration and nationality requirements, although the President retains significant powers and control of foreign, European and defence policies. This scenario would likely upset markets given the negative implications of National Rally’s public spending plans.
• A National Rally relative majority where it becomes the largest single party in the National Assembly, but it has no absolute majority. The outcome would likely be an even more splintered parliament, which could result in a political and policy deadlock for the rest of Macron’s mandate, similar to the current situation.
• A left-wing alliance: On Monday, left-wing parties agreed to form an alliance, but at the time of writing, leaders have not yet agreed on who will head the coalition nor on its programme. If the alliance is successful, it could potentially have substantial influence in legislative decision-making or even a relative majority, which in our view would likely be perceived by market as a risk in terms of the public deficit.

As markets digested the implications of different scenarios for France’s political future, risk aversion plagued the French bond market. The 10-year France-German government bond spread widened to levels seen during other risk-off events, such as the COVID pandemic – but not to levels seen during the 2012 eurozone crisis levels. This reflects elevated political risk exacerbated by the fears around France’s management of its precarious debt situation. Following Macron’s surprise election decision, Moody’s warned that its current “stable” outlook on France’s rating could be cut to “negative” if its debt metrics worsened further. This follows S&P’s downgrade last month, highlighting the French government’s missed goals in plans to restrain the budget deficit after huge spending during the COVID pandemic and energy crisis. Increased leverage in corporates has seen France grow from the second largest to the biggest participant in the Euro Corporate Index, with its share up from 16% at the end of 2000 to 23% at the end of 2023¹.

Market volatility rippled across into corporates with weakness seen in the French banking and utility sectors. So what is the potential impact of a National Rally majority on the regulatory backdrop impacting these sectors and what is priced into markets?

Banks – a tax on banks?

Wider sovereign spreads can have an adverse impact on banks both fundamentally (eg. bond portfolio valuation, cost of funding) and in terms of market dynamics (eg. sentiment, liquidity). The impact of such widening should be limited by the fact that French universal banks such as BNP Paribas, Société Générale and Crédit Agricole are relatively well-diversified geographically and have lower domestic sovereign exposures than many of their eurozone peers.

At the time of writing, there have been very limited details on National Rally-led policies that could directly impact banks. While we cannot rule out punitive measures, we think a tax on bank profits – like in Spain and Italy – is unlikely to be a priority. French banks have benefited less from higher interest rates than banks in other countries, partly because bank loans and deposits are highly regulated already, which has put them at a competitive disadvantage in terms of revenue. National Rally-led policies could also lead to a higher budget deficit and a deterioration in France’s economic situation, driving further sovereign rating downgrades and banks’ ratings in turn.

French bank spreads have widened across the board but moves have so far been relatively muted. Bank bonds typically react more strongly to political and economic events, reflecting their strong link to the economy alongside sensitivity to market sentiment – given leveraged balance sheets and their ample liquidity. While we remain sanguine on French banks’ fundamental profiles, we take a more cautious stance on near-term French bank valuations as political risk remains elevated and spreads moves so far have been limited.

Utilities – shift away from renewables?

For the leveraged utility sector, there is potentially more of a direct impact from National Rally influence, as it has been campaigning on affordability measures and targeting energy bills. In its election manifesto, it advocates for an exit from the European electricity market rules, which has potential implications for utilities in general but particularly for fully government-owned EDF. Given this ownership, we believe it is the most exposed name to political intervention. Possible risks for EDF include:

• An impact on profitability from higher taxes and a lowering in retail energy tariffs if an exit from the European electricity market rules is achieved.
• An acceleration of capital expenditure, as National Rally is pro nuclear and the party’s manifesto has ambitious and possibly unrealistic targets around the construction pace of new reactors.
• Reduction of renewable energy targets, as the party has a lukewarm relationship to renewables.
• Management reshuffle, which could be disruptive considering the recent CEO change.

In the past, EDF has been used as a political tool to manage energy bills in France. That said, implementation of negative measures would be inconsistent with the need to build new nuclear reactors (supported by Le Pen). After all, achievement of this punchy target requires a financially stable and resilient company to carry out these operations and ensure its financing.

Higher taxes also could impact partially government-owned utility Engie. A major pivot in France’s approach to renewable energy might put into question the company’s growth strategy, heavily based on a renewables rollout. That said, a significant share of Engie’s renewable capital expenditure is outside France and the situation could also translate into lower near-term investment needs, which would offset the credit implications for the company in the short term. Deceleration of energy transition in France could also result in lower capex needs for the regulated assets, which would in turn improve leverage trajectory albeit at the cost of future growth. We believe there are limited risks for such regulated names – as regulatory regimes are fairly resilient to political interventions – and water companies where, unlike in the UK, the water sector has not been so intensely politicised.

Political risk can overshadow fundamentals

We have seen an increase in leverage in some utilities across Europe over the last couple of decades. And even where there are no direct policy implications, any changes to new, or non-mainstream, political parties create a risk of policy change when financial strength to adapt is somewhat diminished. So while near-term negative implications may be limited, the recent trouble in the UK water sector, for example, shows what can happen when leverage is elevated, politicians are involved, and operational performance is challenged. Elevated political risk can nonetheless lead to some contagion in parts of the market where fundamentals remain strong or result in higher financing costs for the affected names. We expect further volatility to arise in utilities as clarity unfolds.

Political risk can thus cast a shadow over company fundamentals and create mispriced opportunities. Identifying where such political risks could legitimately impact fundamentals is key for selective credit investors. An interesting market dynamic to note is amid the sell-off in the French names, the weakness in the sterling investment grade market was more pronounced. This serves as a reminder that even among the volatility opportunities can arise where you least expect them.

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IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens. There is no guarantee that past trends will continue, or forecasts will be realised.