Author: Patrick Barbe, Head of European Fixed Income and Senior Portfolio Manager at Neuberger Berman
Now, halfway through a record-breaking election year, we are faced with another election — and one that may well be one of the most important.
Four years ago, we welcomed the arrival of the Next Generation EU fund as a key moment for European unity – a pandemic recovery package that for the first time included financial transfers between European Union member states. Last week, the next phase of these measures was thrown into serious doubt.
The gains made by far-right and eurosceptic parties in the European Parliament elections have not helped the situation, but President Emmanuel Macron's decision to hold early parliamentary elections in France, following Marine Le Pen's National Rally (RN) coming in first in the French European Parliament elections with 31.5% of the vote, poses a major risk.
The euro fell about 1%. French government bond spreads, already under scrutiny due to fiscal pressures and downgrades, widened to their highest in five years, dragging Italian and Spanish spreads down with them. The CAC 40 index fell 3%, with French bank stocks being particularly hard hit. There was an apparent flight to quality bonds, with German bunds performing well.
These are not crisis-level moves, but they suggest just how much uncertainty there is between now and the French elections on June 30 and July 7, and how the sentiment that has kept euro zone bond spreads tight over the past few years is now under threat.
Destructive
The European Parliament, which draws up the EU budget and plays a key role in deciding on legislation, is not as strongly Eurosceptic to the right as opinion polls suggested a few months ago.
The Greens, Social Democrats and Left parties lost significant seats, while far-right and Eurosceptic parties gained seats, although the centre-right coalition gained both seats and percentage, and the far-right coalition became more fragmented with Germany's Alternative for Germany (AfD) being expelled from the right-wing coalition.
One of the first tasks for the parliament is to elect the president of the European Commission, who will play a key role in the EU institutions. There is speculation that the right will try to delay the appointment until the new power structure in France is clearer, but the politics are unusually complex and the current president, Ursula von der Leyen, is the candidate of the main centre-right party group and her votes were strong in the election. Five years ago, von der Leyen won a narrow majority with the help of the votes of the centre-left party group. This time, she is attracting votes from the right, so it is likely to be a close race again, but von der Leyen remains the favourite.
Opinion polls and the Green Party's poor performance suggest European voters are struggling with inflation and are looking for a change of direction on issues such as a green transition, defence and security, borders and immigration.
National governments and the European Commission have arguably already begun to address the latter two issues, but Parliament's new composition is unlikely in itself to upset key pillars of the green transition, let alone threaten programmes already in place.
Overall, we believe the European Parliament will not disrupt the strategic direction of the EU as much as some commentators have suggested, and the election result itself may not be of great concern to investors.
Delegation
However, EU governance requires that EU strategic directions be ratified by national parliaments before they can be implemented at European level.
The next developments in the EU's wider strategy following the Next Generation programme will likely be determined by Mario Draghi's European Competitiveness Report, due for publication this month. The report is expected to recommend closer cooperation to make better use of the EU's size, remove bottlenecks in industry and supply chains, and secure supplies of vital resources.
These upcoming reforms are already at risk as Macron has been without a majority in the French National Assembly for two years.
For example, fragmentation, especially within the center-right Republican Party, led to Macron's key pension reform proposal being controversially passed without a parliamentary vote in March 2023. Macron's party failed to form a coalition government, and most of the other parties are starting the fight to replace Macron in 2027. In addition, the Republican Party's results in the European Parliament elections have significantly weakened Macron's government, and it is likely that the opposition will use this opportunity to introduce legislation aimed at toppling the government this fall. President Macron dissolved parliament to maintain his own leadership and to surprise and destabilize other parties. His current strategy seems to be to rally a majority in the new parliament against the far-right and renew his own mandate, albeit at the expense of the far-right winning more seats.
That is why we believe that Macron faces additional risks not only to his own authority but also to Draghi's reform program, some of which may be rejected if there is a major shift in the balance of power in the French National Assembly.
But if the RN can form a majority in parliament in July, it would have significant implications not just for France but for key parts of Draghi's reform program. The RN could falter at the first hurdle long before it even gets close to the European Parliament, potentially undermining the foundations of the eurozone periphery's recent economic and market strength.
Politics
The political situation is complex and unpredictable. Le Le Pen's electoral success at the European level does not guarantee similar success at the national level, where the stakes are likely to be higher. Her far-right allies, who stand to benefit from the EU's deeper fiscal and market integration, especially Italian Prime Minister Georgia Meloni, may be able to exert some influence over Le Pen. And history shows that the EU is fine-tuning its values to rescue it from crisis.
But the market reaction over the last week suggests what is at stake. At the time of writing, the G7 meeting hosted by Italian President Meloni has begun and may already be a market-shaking news item. Volatility and the widening of spreads between France and the Eurozone periphery are likely to continue at least until the French elections in two weeks, and possibly beyond.
