Markets wake up to left-wing French election risk

FILE PHOTO: French left wing parties campaign for legislative elections in Paris

By Yoruk Bahceli

(Reuters) -For investors in France, a left-wing alliance could be a bigger risk than a far-right leadership, some analysts say.

President Emmanuel Macron's shock decision to call parliamentary elections this month and Marine Le Pen's far-right National Rally (RN) leading the polls have exacerbated concerns about France's fiscal sustainability.

The spread French debt pays over Germany surged and shares in French banks and companies slumped in the days after the election was announced. The selloff has eased but assets are far from recovering.

Spending plans by the leftist New Popular Front (NFP) alliance, which is polling second behind the RN, have added to those fiscal worries.

Some investors and analysts now say the risk that the NFP may perform better than expected in the second election round on July 7 due to tactical voting, and even form part of a new government, may be a bigger worry for financial markets.

"The worst outcome for the market would be if the left wing would get in with the majority... that's the tail risk," said Gareth Hill, a portfolio manager at Royal London Asset Management.

The NFP wants to progressively ramp up spending to an extra 150 billion euros ($160.44 billion) annually by 2027 to cover policies ranging from a 10% civil servant pay rise this year to cutting the retirement age to 60 from 64 currently.

It says the spending would be fully offset by hikes on taxes ranging from inheritance to wealth and multinational corporations.

While the NFP would not increase France's budget deficit if able to form a government, it also wouldn't reduce it, an official said last week.

That's a worry for investors. France's deficit was at 5.5% of output last year - far above the European Union's 3% limit - already prompting the EU executive to recommend disciplinary steps.

In contrast, the far-right RN's financial pointman Jean-Philippe Tanguy told Reuters in an interview published on Monday that the party won't "let the deficit run out of control" and would retain current plans to reduce it to 3% by 2027 to respect EU rules. It has also pledged an audit of public finances.

While it remained to be seen what it would do if in government, the RN at least speaking of fiscal responsibility is "reassuring", said Hill at Royal London Asset Management.

NEGATIVE FOR THE EURO

There's no doubt the RN's costly plans have spooked markets. They include cutting value-added tax on energy and lowering the retirement age to 60 for workers, though the party now says that would only apply to those who started working before the age of 20. It says the cost of its plans can be offset by cutting red tape, closing tax loopholes and reducing welfare spending benefiting immigrants.

Yet, compared to an NFP lead, an RN majority would be welcomed by financial markets, economists at Nomura said in a note distributed on Tuesday. "In our view, NFP forming the government, whether outright or as a minority, would be most adverse for financial markets and result in (French-German bond) spreads widening further,"they wrote, adding it would also be negative for the euro.

"In many ways, the NFP is openly rejecting the institutions that govern fiscal prudence, akin to the UK's Liz Truss," Nomura wrote, referring to the former British Prime Minister's unfunded tax cuts that led to a UK government bond rout in 2022.

Economists at investment bank Jefferies said a left-wing government would be the "worst outcome" for markets if it was the result of Jean-Luc Melenchon's far-left France Unbowed party, part of the NFP, doing well and prompting a far-left policy agenda.

"We could see increased clashes with the EU," Jefferies wrote, expecting the French spread over Germany - currently around 70 basis points - to widen to as much as 120 in such a scenario, assigning it a 20-25% chance.

"The negative reaction in the market could last longer, and it's not obvious to us that this scenario would be consistent with a buy the dip view," they wrote, a position they recommend for most other scenarios including an RN absolute majority.

($1 = 0.9349 euros)

(Reporting by Yoruk Bahceli, additional reporting by Leigh Thomas; Editing by Amanda Cooper and Susan Fenton)