France’s parliamentary elections have already rattled investors as the country’s risk premium rises. However, both possible scenarios have not yet been reflected in the market and could impact stocks in the wider European region, according to Citi.
“Our model suggests that the market is pricing in a positive outcome versus gridlock. It’s not quite there, but it’s a few percentage points away from pricing in a full gridlock,” Beata Manthey, the bank’s global head of equity strategy, told CNBC’s “Squawk Box Europe” on Friday.
“But the market doesn’t reflect that there will be a majority on the far right or the far left,” Mansey said.
The tax and spending plans of the far-right Rassemblement National (RN, or National Rally) party and the left-wing Nouveau Front Populaire (NFP, or New Popular Front) coalition are a major cause of concern about future bond market volatility. Some economists have warned that it could degenerate into a debt crisis if either party forms a majority and moves quickly through most of its proposals.
In Sunday’s first round of voting, both parties appear to have overtaken a centrist coalition that includes President Emmanuel Macron’s Renaissance party. But the path from there seems very uncertain.
From the market’s perspective, the moderate outcome could be either centrists finding a path to victory, or a deadlocked Congress in which neither party can advance their agenda.
Citi conducted a scenario analysis of different outcomes and what this would mean for Paris. CAC40 Stock market indices — also based on potential moves in the spread between French and German bund yields, which hit a 12-year high on Friday.
“The results are still very unclear. We are only voting in the first round of the election. So we will know more on Sunday evening,” Manthey said.
“Let’s think about this election announcement in the context of investor positioning. Europe has been a very hot market, it’s been doing very well, international investors are moving from the US to Europe, positioning has expanded or is net long. In particular, for European banks, it’s been extended for a long time and now everything is neutral but not negative,” he said.
She said European stocks were trading at about a 40% discount to their U.S. counterparts, a “huge” gap compared to the historical average of 15 to 20 percent.
“But valuations need a trigger. Increased political risk is not the trigger, and that’s what concerns me. … Our model suggests that they are currently priced fairly relative to what analysts expect from a fundamental perspective,” she continued.
“Let’s put it this way: We downgraded Europe and upgraded the U.S. based on increased political risk. Within developed markets, European stocks tend to be the most vulnerable to these changes,” she added.
If the French election results are “very unfavorable for the markets… European markets are highly correlated, so if CAC sells significantly, it has a ripple effect elsewhere,” Manthey said.
