Understanding the implications of the French turmoil on the market in one article?

The "election earthquake" in France has dealt a heavy blow to the European markets, with a panic situation of stocks, bonds, and exchange rates reminiscent of the "Eurozone crisis" reappearing, and the current macro environment may imply even higher risks than in the past decade.

Last week, France held European Parliament elections, with exit polls showing the far-right party "National Rally" in a commanding lead. French President Emmanuel Macron immediately announced the dissolution of the French National Assembly and called for new parliamentary elections, throwing a bomb into the French political arena. The latest surveys indicate that not only is the support for Macron's ruling party, La République En Marche, lagging behind Marine Le Pen's "National Rally," but it is also lower than the left-wing alliance "New People's Front."

Henry Allen, a macro strategist at Deutsche Bank, pointed out in a report on June 17th that if the far-right party "National Rally" or the left-wing alliance "New People's Front" come to power, they will push for fiscal expansion, leading to more conflicts with the EU and significant changes in French policies.

Last Friday, the "New People's Front" announced its governance plan, reversing much of Macron's economic agenda. For example, they plan to lower the retirement age to 60, increase the minimum wage, reinstate the wealth tax, freeze prices of essential goods, and reject EU deficit rules. The "National Rally" also promises increased fiscal stimulus, including lowering the retirement age and reducing fuel and energy taxes.

Deutsche Bank believes that higher real yields and higher debt levels mean that the risks of fiscal stimulus measures are much higher than in the past decade; furthermore, inflation pressures suggest that if there are growth shocks, especially if the currency further depreciates, central banks like the European Central Bank may find it difficult to significantly cut interest rates.

Moreover, political event risks may persist for some time, as by October 2025, 6 out of 7 G7 countries will hold parliamentary and presidential elections.

Deutsche Bank summarized five major market insights into the chaos in the French political arena.

1. Markets are more sensitive to fiscal stimulus risks

Deutsche Bank points out that in today's environment of rising yields and debt, fiscal stimulus is a riskier proposition.

Since the pandemic, nominal and real yields have risen significantly, making markets more sensitive to the cost of additional debt, in stark contrast to the 2010s when interest rates were at historic lows, and the cost of additional debt was relatively low.

Higher rates and debt levels mean that governments need to allocate more and more spending to pay interest on debt, a trend particularly evident in France. Since 1974, France has never had a budget surplus, and the debt-to-GDP ratio has increased from 21% in 1980 to 110% in 2023, growing fivefold.

Deutsche Bank believes that concerns about fiscal stimulus triggering market turmoil are not just a theoretical possibility, as seen in September 2022 when the UK's mini-budget led to a massive sell-off of government bonds, causing global market turmoil until the government announced the rollback of most policies

2. Market turmoil may be self-fulfilling

Deutsche Bank pointed out that an important lesson from the Eurozone sovereign debt crisis is: market turmoil often self-fulfills from within, with turmoil usually occurring suddenly rather than gradually accumulating.

The "vicious cycle" between banks and sovereign states is a typical example. In this scenario, banks are exposed to sovereign risk due to holding government bonds. However, as the bond value declines, the government may face negative risks from banks as they may need to rescue them, creating a mutual entanglement that rapidly deteriorates negative expectations.

Sovereign debt itself also exhibits a similar negative feedback loop. As interest rates rise, government borrowing costs increase, weakening market confidence in the government's debt repayment ability, leading to further interest rate hikes.

Deutsche Bank believes that this reaction is non-linear, with a critical point, and once market confidence is lost, it is difficult to recover. Therefore, the market may suddenly experience selling pressure in a short period of time, as seen in the market reaction triggered by Macron's unexpected announcement of elections last week.

3. Inflation pressure limits the ECB's monetary policy easing capacity

During the Eurozone debt crisis, people were generally concerned about deflation, fearing that the Eurozone would follow in Japan's footsteps with the ECB maintaining low-interest rate policies for a long time. In contrast, the Eurozone's inflation rate is currently at 2.6%, with a core inflation rate of 2.9%, exceeding the ECB's target for nearly 3 years.

Therefore, if inflation continues to exceed the target, this will limit the ECB's ability to loosen policies in the face of growth shocks. Additionally, if policymakers pursue more fiscal stimulus, this may exacerbate inflation pressure, forcing the ECB to maintain higher rates for a longer period.

Deutsche Bank also pointed out that if these policies damage market confidence and lead to currency depreciation, imported inflation could become another factor leading to long-term high-interest rates.

4. Political risks will persist

In the next year, 6 out of the G7 countries will hold parliamentary or presidential elections, indicating that political and policy uncertainties are expected to remain high in the coming year.

In France, the first and second rounds of parliamentary elections are scheduled for June 30 and July 7 respectively. Subsequently, the UK will hold elections on July 4. Then, the US presidential election will take place on November 5. Looking ahead to 2025, Germany, Canada, and Japan will also need to complete elections by the end of October, or even hold them earlier.

Deutsche Bank stated that it is difficult to predict in advance which election will have the greatest impact, but the political turmoil in France last week, as well as the earlier Brexit event in the UK, indicate that election results could lead to significant market volatility, especially in unexpected outcomes.

5. Significant differentiation between the US and European markets

In recent years, global markets have mainly traded around similar themes, with global monetary policy cycles largely synchronized, mainly responding to different scenarios of global inflation surge through rate hikes. However, now that the ECB has started cutting rates, political uncertainty is rising, and the European market is beginning to diverge from the US market trends. Last week, the S&P 500 index rose by 1.58%, while the European STOXX 50 index fell by 4.20%. This marks the largest weekly difference between the two major indices since the Russia-Ukraine conflict in March 2022. At the same time, the European volatility index V2X reached 19.87 points on Friday, the highest level since October last year, while the US "fear index" VIX remained at 12.66 points, slightly higher than the lowest closing point of 11.86 points since the pandemic.

Deutsche Bank pointed out that this is the first time in recent times that such a huge divergence has been witnessed between the US and European markets, with different trading themes emerging in the two major markets