Markets overestimate European political risk 

• Enguerrand Artaz
  Strategist
  La Financière de l’Échiquier (LFDE)

Until then, other European assets had remained largely immune to the stress surrounding France’s budgetary situation. However, in recent days, as equity markets came under pressure, spreads for many countries widened. The Italian-German and Greek-German 10-year yield spreads thus widened by nearly 30 bps (0.3%), while the Spanish-German 10-year spread widened by 15 bps. Even the Portuguese spread widened, despite the fact that the country likely has one of the strongest debt and deficit trajectories in the eurozone.

This phenomenon, which is reminiscent of the 2011–2012 sovereign debt crisis, also stems from a near-Pavlovian market reflex: when political issues increase in Europe, investors – particularly international ones – tend to adopt a wait-and-see approach. It is true that, beyond the situation in France, several European countries have significant items on the agenda, such as Germany with its recent regional elections, and Spain, which has just announced early elections for 29 November. Not to mention Italy, where parliamentary elections are due to be held by the end of 2027. However, there seems to be far less at stake in these cases than in the upcoming presidential election in France.

In Germany, Chancellor Merz’s position has been undeniably weakened by the recent defeats of his party, the CDU. It seems unlikely, however, that the governing coalition will collapse before the 2029 election. Given the current polls, snap elections could lead to a political landscape that makes forming a new alliance highly complex. The ruling parties would therefore have a great deal to lose, precisely at a time when public investment plans are finally beginning to gather pace. In Spain, while the economy is experiencing a period of strong growth, the country will soon have to deal with losing some of the European funding it has received in recent years, and consequently exercise somewhat greater budgetary discipline. Such an environment will call for a strong, newly (re)elected, government majority. It is therefore difficult to see these elections as posing a major economic risk. Finally, in Italy, the opposition remains fractured, and the recently passed electoral law could bolster the current Italian Prime Minister’s right-wing leadership. There is therefore a strong likelihood that Italy’s longest period of post-war government stability will continue.

In light of these factors, European political risk – and the associated economic and fiscal risks – appears overstated, and the risk of financial contagion beyond issues in France seems largely unjustified. For investors, this may actually come as good news. Indeed, if the risk of contagion to the rest of the eurozone continues to be over-exaggerated, it could prompt a swift response from the ECB, which is far more sensitive to this risk than to the situation of any single country. At this stage, the absence of an explicit central bank ‘put’ (or safety net) is troubling the market. An intervention by the ECB – even in the form of a statement and not involving the anti-fragmentation mechanism – could reassure investors and enable a rebound in European assets. Moreover, the recent developments create opportunities to revisit sectors or themes that had performed well and where the positioning might have become a bit too consensus-driven, such as the banking sector.

We should obviously keep a close eye on the situation in France, especially given its systemic nature for the eurozone. However, investors need to take a step back and view the European situation in perspective; overall, it is far from being as bad as it might seem.

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