What investors should know about political turmoil in France

Executive summary:

• As political chaos engulfed France, the spread between French and German bond yields widened to 90 basis points before narrowing late in the week
• We view European equities as close to fair value 
• The U.S. services sector continues to look relatively healthy 

On the latest edition of Market Week in Review, Investment Strategist BeiChen Lin discussed the ouster of France’s prime minister and the potential market implications. He also provided an update on the health of the U.S. economy.

French bonds under pressure amid political chaos

Lin began by unpacking the latest developments from France, which was thrown into political turmoil earlier this week when lawmakers ousted Prime Minister Michel Barnier in a no-confidence motion. “Barnier invoked article 49.3 of the French constitution–which allows the government to pass legislation without the approval of parliament–to try to ram through a budget bill. This upset some French lawmakers, with both right- and left-wing parties filing a no-confidence motion against the prime minister,” Lin said.

The motion passed with 331 votes on 4 Dec, Lin said, forcing Barnier to resign as prime minister the next day. French President Emmanuel Macron will now need to nominate a new prime minister, he noted, adding that in the interim, Macron can appoint a caretaker government.

The political crisis spilled over a bit into French fixed income markets the week of 2 Dec, Lin said, with the country’s bond market showing some signs of strain. For instance, the OAT-Bund spread–the difference between the yields on French and German government bonds–widened to around 90 basis points (bps) earlier in the week, he noted.

“The spread has since narrowed to around 80 bps–similar to where it was during the French elections earlier this year. That said, the OAT-Bund spread is still relatively wide compared to the past 10 years, showing that investors are still somewhat anxious about the French fiscal situation and the government’s debt levels,” Lin stated.

He said the spread is likely to narrow if lawmakers can reach an agreement on a new budget for France, but the timing around when that could happen is uncertain. As a result, Lin said the strategist team at Russell Investments is staying close to its strategic asset allocation and is prepared to dynamically respond should an unsustainable extreme arise.

Our view: European equities close to fair value

Unlike the bond market, the French equity market largely took the political chaos in stride, Lin said. Case-in-point: France’s benchmark equity index, the CAC 40, actually rose 2% over the past five days, he noted. 

Why? Lin said it’s important to understand that while the CAC 40 is an index of French companies, many of the companies in the index are large global enterprises that derive a significant amount of their revenue from outside of France. “These companies are therefore somewhat more insulated from French fiscal uncertainty,” he explained.

As for how the fiscal uncertainty in France may impact European markets overall, Lin noted that the region’s economy is also facing headwinds from recent signs of subdued German economic activity and relatively weak luxury goods demand from China (a key customer base for many European luxury goods). However, he stressed that these headwinds are largely offset by cheaper valuations compared to the U.S.

“Ultimately, at Russell Investments, we think European equities are close to fair value. On balance, this combination of factors means sticking close to a strategic asset allocation may be the more beneficial choice for now,” Lin stated.

What does the latest U.S. economic data suggest?

Lin finished with a look at the latest U.S. economic data, some of which he characterised as encouraging. For instance, November’s manufacturing PMI (purchasing managers’ index) from the Institute for Supply Management (ISM) came in somewhat above expectations, at a reading of 48.4, Lin said. A reading above 50 indicates expansionary conditions, while a reading below 50 indicates contractionary conditions.

“Despite still technically being in contractionary territory, this was the highest PMI reading for the manufacturing sector in five months. In addition, the new orders subcomponent of the index rebounded back above 50, which is a promising sign,” he stated.

Turning to U.S. services, Lin said the sector remains in expansionary territory, although November’s PMI survey did come in below expectations, at a level of 52.1. “Consensus expectations had called for a reading of 55.5,” he said, adding that the November number was also a step down from October’s reading of 56.0. However, October’s reading was the highest in over two years, which set a high hurdle, Lin said. “The latest numbers still suggest a relatively healthy services sector,” he remarked.

Overall, Lin said the latest data continues to suggest that the U.S. economy will probably avoid a recession in 2025. “However, I don’t see recession risks as completely off the table,” he stated, adding that the team’s full market insights for the year ahead will be available in Russell Investments’ 2025 Global Market Outlook, which publishes Tuesday, 10 Dec.