Executive summary
This week we look at three critical issues:
- Snap elections in France: what does it mean for the economy? President Macron’s decision to call for snap elections came as a surprise. The Franco-German 10yr spread has now risen by +21.7bps since the start of the week, the biggest weekly jump in the spread since the height of the sovereign debt crisis in late-2011. According to polls, a minority far-right government currently has the highest probability. We continue to believe that it would be short-lived – if happening at all – and that a technocratic/ Front Républicain and Macron-backed minority government could be coming in before the end of the year to avoid a hung parliament impasse. Under this scenario, we expect the public deficit to remain close to -5% of GDP by 2026 and growth to be unaffected. Markets would buy the dip. What could go wrong? A far-right government would dent growth by -0.3pp, increase the deficit to -6.5% of GDP by 2026, push OAT spreads at 80 to 100bps, corporate spreads between 110bps higher to 210bps and derail equity markets by -10%. vs pre-election levels. This is both a lot and little, thanks to the ECB put when it comes to markets, and the general resilience (resistance) when it comes to the real economy.
- The equity risk premium puzzle. Attractive fixed-income yields are not distracting investors from equity markets despite the expected economic headwinds. While the upward momentum is somewhat justified, the trend defies the conventional wisdom of Equity Risk Premium (ERP) metrics, which suggest investors may be paying an increasingly larger premium – especially in the US, where the ERP currently stands at 0% (compared to 5% in the Eurozone). The continued acceleration of market-based ‘perceived ERP’ suggests that the equity outperformance may be a self-fulfilling prophecy, reinforcing forward-looking expectations in favour of equities and discouraging investors from rotating into fixed-income positions. Yet, the upcoming policy pivot and its expected effect on the long end of the curve mean that risk-free yields may not be as attractive as they are today for a while.
- Fed: Will the conundrum of easy financial conditions soon be resolved? The Fed now projects only one rate cut this year amid still too hot (though easing) inflation. We expect the Fed to start its rate easing cycle in December and have marginally pushed our end-2025 rate forecast to 4%. Although elevated interest rates are pressuring segments of the economy, broad monetary and financial conditions are not as tight as they appear, creating a conundrum for the Fed. We expect liquidity to contract soon as the Fed continues with Quantitative Tightening. Tighter Fed liquidity should start to tighten financial conditions heading into 2025, helping the central bank rein in excessive inflation.