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France buys time, the markets are reassured…
From a financial markets standpoint, France seems to have avoided the worst case scenario. The problem has not been resolved, but the country has bought itself a few more years of slipstreaming behind Germany and the ability to benefit from near-zero interest rates. And, although the second round of the election is yet to come, it is extremely improbable that France will end up with a euro-sceptic, populist government. This was not so clear on Friday.
 
Although the long term situation has not changed and France remains in a stalemate with respect to the reforms necessary to allow it to extricate itself from the cycle of budgetary and economic gridlock, the short term situation has vastly improved and we expect to see spread-tightening and rate declines in several asset classes in the days to come:
 
1/ The French OAT, which saw the 10 yr spread over German bonds widen to a historically high 75bp, should rally relative to all European countries. Already today, the spread has dropped by 25bp, which we expect to continue in the coming weeks, ending with a France/Germany spread of 20-40bp.
 
2/ Peripheral country bonds, which by association saw their spreads vs Germany widen for the past several weeks. A Euro-sceptic government in one of the EU and Eurozone’s founding countries would have represented a major threat to the existence of the Zone.
 
3/ Financial bonds (especially subordinated); it’s not that the probable new president’s past encourages us to make specific forecasts or shaky assumptions, but the relationship that the banks have with the government and the country’s economic and financial situation have made them vulnerable (even moreso for their creditors) to a government which is considered a Euro-sceptic and/or is not positively disposed to a market economy.
 
4/ Corporates: the impact on corporates should be less pronounced as most European corporates are regionally diversified and more highly correlated with the Bund than the OAT, which has become more of a derivative than a bellwether, due to France’s loss of economic and financial influence at the heart of the Eurozone and the EU. Only a few corporates with strong ties to France or without any regional diversification, and which have therefore underperformed in the past few weeks, are likely to see substantial spread tightening. We would highlight Areva, whose future and restructuring process could be derailed by the electoral success of certain parties. Impacted to a lesser extent, will be companies such as La Poste, EDF, Orange, the automakers, and real estate, where links to the government or its politics are relatively strong.
 
More generally, the sluggishness of the past few weeks, the risk-neutralization of many PMs’ portfolios and the massive flows into money market funds, could mean that we are in for a few weeks of excitement prior to the summer, with a pick-up in the primary market for subordinated bank debt, greater participation by institutional investors who have been waiting months for better visibility and increased interest in risky assets despite their extremely low yields.
 
In our opinion, although the election has turned out well for French rates and it is not necessarily a sufficient catalyst to warrant massive repositioning into the riskiest of assets, it may allow investors to earn a reasonable return by investing in traditional CSPP assets, a few subordinated Tier 2 banks with 5 – 10 year maturities and a small high yield weighting, which will be possible to acquire in the primary market over time. However, we remain extremely vigilant as the French election was only one of many hurdles to clear this year. There remains ample danger and uncertainty: American economic policy, geopolitics, the economic trajectory in China, and Brexit are examples of things which must continue to be closely watched as they have a much greater potential to impact portfolios than our regional election.
 
 


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