Merlin Weekly Macro: France’s fiscal woes rattle bond investors

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Gallic gallstones

It’s that time of year. The French parliament is about to go to war with itself again in the annual budget row. The current administration intends an austerity programme to make an additional €43 billion of “recovery measures” to be met by cost savings, freezing public sector wages and increasing taxes. Heightened by the political tensions created by a looming presidential election next April, the social blue touchpaper has been lit. Today it is the French students, supported by their teachers and parents, variously protesting and rioting over the quality of French education and its infrastructure. Demonstrating and rioting are national pastimes in France; had it not been the students being energised about education, it could easily have been the Gilets Jaunes on the march about fuel costs, the far-right cutting up rough about immigration or the farmers indulging in casual muck spreading of government buildings or barbecuing lambs by torching cattle trucks on a motorway in protest at everything in general. Whatever, France is in the news for all the wrong reasons again.

France is not a failed state. Parliament might be implacably divided and the government reduced to near paralysis but society is still functioning normally even if there is an air of febrile tension and widespread periodic civil disorder. But it is failing and it could yet fall over.

 “Between Bonds and the Barricades!”

More accurately the headline should be “Between Bonds, the Barricades and the Bank!” France’s finances are a mess: debt/GDP is 119% and an intractable budget deficit, incapable of serious reform, remains stubbornly over 5% of GDP. Productivity is poor, growth nugatory. Under the eurozone financial stability mechanism, member states’ debt/GDP should not exceed 60% while the budget deficit should be below 3%; France fails those tests by almost 100% and by the EU’s own definition must be contributing to eurozone instability. Practical measures including pension and welfare reform to address both the debt and the deficit have defeated successive French prime ministers during Macron’s presidency. The latest, Sebastian Lecornu, has only endured for a year in post through enforced political paralysis allowing nothing to change. Survival is itself an achievement, even if tangible improvements elude policy makers and simply store up greater trouble later.

And that trouble has already arrived. Bond investors have little confidence that French parliamentarians will have any greater success improving the fiscal outlook this side of the presidential election in April 2027 (in which Macron is ineligible to stand having served the maximum number of terms allowable). Adding to the concern is France’s obligation to meet NATO’s defence spending requirement of 3.0% of GDP by 2030 and 3.5% on core defence (things that go bang) plus 1.5% of GDP on “resilience” by 2035; its current core defence expenditure is only 2.2% of GDP. As political sentiments harden and polarise between the far-Right and the far-Left, especially with an almost inconsequential middle ground, when considering the fiscal options nobody is in any mood to compromise. Not only is the economy a battleground, but fiscal and economic policy are being weaponised for political advantage with ever more radical solutions. Some are simply mad. Bond investors are wargaming the potential outcomes that if they lend their money to the French government, what is the likelihood they will ever see it again.

Marine Le Pen and her far-Right National Rally party currently have a 17-point lead over Jean-Luc Mélenchon’s hard-Left La France Insoumise. 2027 will be Le Pen’s fourth attempt to be president. Her popularity has been enduring and growing but in the two-round voting process, even where she has competed well in the first, a majority determination to keep her out has meant victory has eluded her in the second. Peering ahead, unless the centrist parties can coalesce in numbers around a credible unifying candidate, political pundits are less confident today that she will be denied the presidency in 2027 when the only apparent alternative appears to be the political polar opposite in Mélenchon.

Headbanger proposals

Electioneering has effectively already started. Le Pen has been taking to the airwaves pledging to address the deficit, determined to bring it down to 3% of GDP by cutting €140 billion of public expenditure. Markets initially reacted well.

For all that she is right-wing when it comes to social policy (e.g. she is anti-immigration and would remove benefit payments to all foreign nationals etc), she has a largely socialist outlook on fiscal policy: for example, she advocates new wealth taxes and taxes on share buy-backs, as well as wanting to reduce the future retirement age by two years to 60 for people who are young today.

However, one big element of the Eurosceptic Le Pen’s calculations is halving France’s contribution to the EU’s operating budget. However populist, without “Frexit” from the eurozone (which itself would pose a systemic financial risk not just to France but the entire bloc), this idea is for the birds. Firstly, Brussels will simply not allow it: members’ freedom to opt in and out of fiscal obligations to the EU is understandably verboten, especially for France given it is the second biggest economy in the EU; second, under the Commission’s new 7-year spending plans extending into the 2030s, in a new fiscal landgrab led by Commission President Ursula von der Leyen and endorsed by Euro MPs, Brussels is looking to raise €2 trillion for strategic investment in defence and resilience. France will be expected to be a significant contributor.

Le Pen’s chief opponent, Mélenchon, is demanding that the French bonds bought by the European Central Bank in the almost decade-long period of quantitative easing are simply written off. Euphemistically it is known by proponents as “debt forgiveness”. It is nothing of the sort: it is default. The ramifications of a French default would not be confined to France itself (nobody would ever lend to it again; its economic and social fabric would implode). As a member of the eurozone, France no longer possesses its own currency; France defaulting on its bonds would melt both the euro as a currency (it is one of the cornerstone global reserve currencies) and the eurozone economy which accounts for 14% of global GDP; a new global financial crisis could well follow as a result (remember the almost cataclysmic effect of the eurozone’s near financial collapse caused by Greece a decade ago: France’s economy is more than ten times the size).

Lagarde and the Judgement of Solomon

And so to the European Central Bank. There is an informal line in the sand that divides order from chaos. That line is defined as any eurozone member state whose 10-year national bond yield exceeds that of Germany’s by more than one-and-a-half percentage points (150 basis points), beyond which the risk accelerates of financial disintegration becoming self-fulfilling. In 2022 Italy came close to breaching the spread barrier when it endured one of its periodic banking crises. Fearing another Greek-style event, the ECB stepped in with an emergency “antifragmentation” mechanism designed to restore stability. It removed the ability of speculators to arbitrage the differences in national yields and their propensity to create mayhem along the way to make a quick buck. Introducing a mechanism known as Transmission Protection Instruments, in a pincer movement to close the gap the ECB would sell German government bonds forcing the yield up while buying the bonds of the country under stress thereby forcing that yield down.

Despite all the self-inflicted stresses of recent French budgets, the political instability in the government, the paradoxical paralysis in policy etc, the spread between German and French 10-Year yields has remained stable at around 75-85 basis points since the TPI was introduced. Until the beginning of October.

Bond investors were already preoccupied with the deficits and debt of major western economies, and now the inflation pressures evident from the Iranian and Ukrainian wars. They were pushing yields to three-decade highs in anticipation of further monetary tightening by the central banks. As rising financing costs only added to the deficit pressure, suddenly in reaction to these wild political announcements in France and exacerbated by the student riots, the Franco-German yield spread burst open, almost doubling. At one point it exceeded that 150bp red-flashing warning signal. At the time of writing, the French 10-Year bond carries a yield of 4.92% against the German equivalent of 3.51%, a spread of 141 basis points. It remains in the danger zone. It must be remembered that for almost the entire period spanning mid-2019 and the end of 2021, the yield on the French 10-Year bond was negative: lenders were paying France to borrow; bond investors and the ECB which had a policy of negative interest rates cannot duck their own responsibilities for today’s mess. It was quite obvious at the time that such behaviour was reckless and irrational, actively encouraging the French government (and others) to borrow, borrow and then to borrow some more with no thought for the consequences.

Normally the ECB would take immediate stabilising action under the TPI. But actively selling German bonds to raise the yield would have put unnecessary strain on Germany’s own sharply rising borrowing costs at a time it too can ill afford it. So, taking courage in both hands ECB President Christine Lagarde did something very different. Notwithstanding the ECB’s share of indirect culpability, she threw down the gauntlet to the French government: this is a French problem that France must solve, it is not the responsibility of the European Central Bank to sort it for them. Turning off the safety valve and cutting France loose like this is a big call. Remembering the Greek crisis, is she calling the markets’ bluff or is it the other way around?

It is instructive how investors are appraising the situation. They subsequently priced a new corporate bond issue from investment grade French industrial gases giant Air Liquide at a lower yield than the comparable French government bond of the same duration (i.e. lenders see Air Liquide as a better bet and less of a financial risk than the French government).

Lagarde is correct: this is a French problem. It is also a political football. Nobody has yet found the solution or wholly credible alternatives that get the country out of its jam, let alone a plan that restores its fortunes. When they do find the solution, the political imperative requires effective leadership to explain clearly to the electorate why remedial actions are necessary as well as what they are and how they will be implemented. This is especially the case where the temptation of the path of least resistance for the electorate can only lead to a much deeper and more enduring crisis later.

Plus ca change

But the final warning must be to Lagarde, Von der Leyen and the other leaders of the eurozone: half of the EU’s mess is that quarter of a century after monetary union was completed, the European Union remains an unfinished political project with no prospect of full union in sight. Fiscal policy remains national; trade regulation and policy are entirely centralised, so too is monetary policy: this is an obvious structural nonsense. Populism rising across the EU reflects the reaction to the fundamental democratic deficit in the EU as national electorates are increasingly distanced and dislocated from centralised policymaking giving the impression of disenfranchisement. As is all too clear, centrist European governments are making a poor fist of dealing with populism. The result is both political instability and potentially irrational policies. That in turn merely feeds the need for bond investors to demand higher yields as compensation for lending in such volatile circumstances.

As German and French ministers offer platitudes and seductive mood music to the UK, the aforementioned considerations might concentrate Mr Burnham’s mind as he ponders closer alignment with the EU and he pitch-rolls another EU referendum to take us back in.

The French and the British enjoy a rich history of mutual schadenfreude. The current French farce would be comical if it were not so serious. Have a laugh but not too hard. The joke could soon be on us too.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.