By Yörg Bahçeli and Samuel Indyk
(Reuters) – French President Emmanuel Macron’s surprise decision to call elections with opinion polls suggesting a far-right victory could be won has rattled financial markets and further raised concerns about the fiscal sustainability of the euro zone’s second-largest economy.
The market has stabilized since the June 9 announcement, but is far from recovered.
Polls show Marine Le Pen’s National Rally coming in first but not winning an absolute majority, making investors nervous ahead of two rounds of voting on June 30 and July 7. Investors are weighing the fiscal security of the National Rally against the risk of overspending by the Left Alliance, which is coming in second in the polls.
Here are five key questions for the market:
1/ Will French government bonds face further difficulties?
The risk premium, or spread, that holders of French government bonds demand over German government bonds has jumped to about 80 basis points, approaching levels last seen during the euro zone debt crisis last decade.
They have calmed down now but remain more than 25 basis points higher than they were before Macron called elections.The bond market is reflecting expectations of a “hanging parliament where no party can get much done,” said Gareth Hill, a portfolio manager at Royal London Asset Management.
The Finance Ministry estimates that if the market remains at current levels, France could face an extra 800 million euros ($857.92 million) in the first year, an extra 4 billion to 5 billion in the fifth year and 9 billion to 10 billion euros in the 10th year.
An absolute majority for either the far right or the left would allow for more spending plans to be implemented, but the spread could rise further. Encouraged by RN’s comments on fiscal sustainability, many analysts see a left majority as a bad outcome for markets.
Whether Macron steps down may be key: Citi estimates that France’s spread could rise to 130-135 basis points if the far-right and far-left carry out most of their policies without Macron, compared with 100-105 basis points if he stays in office.
2/ Will the unrest spread to Italy and other countries?
The turmoil in France has also widened spreads in the “periphery” of highly indebted European Union member states.
But volatility has been contained. Italy’s spreads have risen to their highest since February, but at around 160 basis points, they are not a cause for concern.
Any further impact should be smaller than in 2017, when Ms Le Pen’s pledge to leave the euro and the European Union, then her subsequent departure, caused widespread shaking in EU bonds.
“Given the lack of anti-euro rhetoric, spillover to the periphery should be limited,” said Peter Goves, head of developed market sovereign bond research at MFS Investment Management.
But tensions between the new government and the EU could limit further European integration and “increase the vulnerability of peripheral countries to any shocks,” Bank of America said.
3/ What will happen to banks?
French banks have been among the biggest losers in the turmoil, with shares in the three biggest banks – Société Générale, BNP Paribas and Credit Agricole – falling between 9 and 15 percent since Macron’s announcement.
“French banks are highly indebted and will be hit by rising credit costs or a surge in borrowing at government level,” said Nathan Sweeney, Marlborough’s chief investment officer for multi-asset.
“With Le Pen, would that mean a temporary income tax or a dividend tax? It creates uncertainty for the banks,” he added.
Barclays equity analyst Sam Moran-Smith said the earnings risks facing French banks at this stage were limited and that there was an overreaction at this stage given that share prices were already weak before the election announcement.
But Moran-Smith said Societe Generale and Credit Agricole pose greater risks than BNP, given the latter’s more diversified geographic and business mix.
4/ What about other French stocks?
The broader French market is no exception: The blue-chip CAC 40 index has fallen more than 5% since President Macron dissolved parliament.
Infrastructure and utilities stocks were the hardest hit, with Vinci, Effage and Engie all falling between 10 and 13 percent since the election results were announced.
The RN had previously pledged to nationalise motorways but the new platform excluded such plans, and in the current election campaign it has floated plans to ignore EU rules on electricity prices and tighten taxation of special profits from generators.
Corporate debt has also been hit: French companies are the largest group in Europe’s corporate bond market, accounting for 23% of the ICE BofA index, according to Janus Henderson.
5/ For the euro, is this a loss for both sides?
The euro has fallen 1 percent against the dollar since the election was announced, hitting an eight-week low on Wednesday.
Lee Hardman, senior currency economist at MUFG, said while a hung parliament would be negative for the euro, the worst outcome would be for the RN to win a majority.
“In that scenario, EUR/USD would likely break out of the new lower range and head towards parity levels.”
Hardman said the Swiss franc would benefit most from further political uncertainty, given its role as the region’s safe haven currency.
(1 dollar = 0.9325 euros)
(Reporting by Jörg Bahceli and Samuel Indyk; Additional reporting by Dara Ranasinghe and Lee Thomas; Editing by Amanda Cooper and Tomasz Janowski)
