Since this month’s European parliamentary elections, markets have factored in greater political risk, spearheaded by the snap French election. This is clear in equity valuations, which were already perceived as high and under scrutiny, and in tight credit spreads showing signs of widening. Additionally, European assets have lagged US assets over the past week. 

We have witnessed similar scenarios before – such as during the Cypriot financial crisis, the Scottish independence referendum and the 2017 French elections – where the impacts were short-lived but marked by a surge in volatility before risk-on market sentiment returned. In this week’s Simply put, we ask: how serious is this situation, and more importantly, what exactly are markets trying to price in?

A French story, rather than European

First, investors need to remember that the wide coalitions forming the European Parliament have actually seen little change in their acquired number of seats. Notably, the centre-right European People’s Party gathered 192 seats, although the European Parliament saw a limited shift to the right. However, the situation in France is different: the Rassemblement National (RN) party won more than 30% of the votes, prompting the centrist President Emmanuel Macron to call a snap election for France’s lower chamber in an attempt to regain legitimacy.

This situation is reminiscent of former UK Prime Minister David Cameron's actions, where the EU referendum was treated as a vote of confidence in his leadership – and failed miserably. The RN, known for its anti-EU programme and readiness to increase spending, draws many parallels with the failed UK budget last year under PM Liz Truss alongside Cameron’s EU referendum. Additionally, France, in tandem with Germany, is seen as a historic pillar of the European Union, especially since Brexit.

As a consequence, the French fiscal premium has risen (see Figure 1), with the progression of French bond yields versus German bond yields. The important point here is that the EUR/USD exchange rate has declined marginally, indicating that this does not seem to be a systemic problem for Europe but rather one focused on France.

FIG 1. French OAT yield spreads (left) and the recent EUR/USD evolution (right)Source: Bloomberg, LOIM. As of 15 June 2024. Past performance is not a guarantee of future returns. For illustrative purposes only.

Wildfire spreading?

Well, this is not entirely true. While the European nature of the risk is not particularly reflected by the euro, it is somewhat apparent in other places. When comparing the evolution of European XOVER spreads and CDX HY in the US, the difference in trajectory is obvious: recently, XOVER spreads had widened up to 40 basis points, four-times the level of CDX HY, which was also up (see Figure 2). The joint increase of both indices demonstrates how this rise in political risk affects the broader market, particularly across aggregate ‘risk-on’ European indices.

The same can be said of equities. The Eurostoxx now lags the robust S&P 500 by a wide gap (see Figure 2). This rise in political risk seems to have resulted in a return to ‘lazy investing’ – i.e., investors reverting to the structural equity trends of the past four years, notably US tech. What these charts show is that political risk – a factor known to be short-lived – is currently spreading across markets.

It would probably be wrong to dismiss this too quickly and to expect it to only impact bond spreads. As government bond spreads widen, the European Central Bank (ECB) could intervene should it become a systemic issue for Europe. But against the underperformance of European equities, the ECB cannot do much – a risk factor that we will continue to monitor.

Figure 2: CDS spreads comparison (left) and equity indices recent evolution (right)

Source: Bloomberg, LOIM. As of 15 June 2024. Past performance is not a guarantee of future returns. For illustrative purposes only.

What this means for All Roads

Amid mounting risks, our models are on the move. As investors who focus on risk premia, we understand that maintaining diversification usually means being less invested in riskier assets and more exposed to assets with a lower level of risk. When realised risk rises, our allocations start to adjust (see Figure 3). At the moment, increased volatility is primarily affecting fixed-income markets and that is where the shift in our exposure has been most substantial.

Within our Balanced strategy, we have reduced our allocation to French OATs by just under 1%, while our equity exposure has remained steady. Should risk continue to rise, further rebalancing of risks in our portfolio will be made.

FIG 3. Evolution of All Roads’ exposure to European assets

Source: Bloomberg, LOIM, as at 15 June 2024. The allocation presented here reflects the All Roads Balanced profile. Allocations subject to subject to change.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our growth indicator improved this week, as more positive data were published in the US
• The message from our inflation nowcaster remains the same: inflation risk is gradually resurfacing, mainly in the US
• Our monetary policy indicator continues to anticipate a moderately dovish tone from central banks

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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