What's next for markets after far-right EU election surge shocks French voters?

Europe Grapples with Political Shifts Amid Far-Right Gains

Following a sweeping win for far-right parties in the European Parliament elections, financial markets are now grappling with heightened political risks. The euro, French stocks, and government bonds suffered on Monday as investors speculated on the far-right's influence in future elections and its impact on the European Union's executive branch.

Market Impact of France's Snap Election

French equities took a hit after President Emmanuel Macron called for a sudden national vote, in response to Marine Le Pen's National Rally's (RN) gains. Leading financial institutions like BNP Paribas and Societe Generale saw shares plunge by up to 8%. Analysts pointed out that banks and utilities are likely to face the brunt of this uncertainty, especially with concerns about a potential bank tax being pushed by populist factions.

The ripple effects were also felt in the bond market, with French government bonds facing potential aversion from major investors. This follows S&P cutting France's credit rating, driven by fears of non-compliance with the EU's deficit rules. Deutsche Bank noted a robust performance from the Socialist party, which added another layer of financial concern. The French/German 10-year bond yield gap widened by seven basis points to 55 bps but remains below previous highs.

Mark Dowding of BlueBay Asset Management predicts that French assets may underperform, and EU assets could also be affected, adding a European risk premium. He expects France's spread to potentially exceed 70 bps if the RN consolidates its gains.

Threat to European Integration

The rightward shift in Europe could hinder further economic integration within the EU. During the pandemic, the EU made strides toward a fiscal union with an 800-billion-euro recovery fund. A continued conservative turn could weaken the momentum for such initiatives. Although the risk premium on Italian bonds increased, it remains within manageable levels. Citi analysts warn that diminished prospects for initiatives like the recovery fund could raise the structural risk premium on high debt nations' bonds.

Climate Policy Concerns

The recent elections also dealt a blow to the Greens, which could complicate the passage of new climate legislation and introduce loopholes in existing laws under review. A right-leaning European Parliament might ease up on renewable energy pressures and could offer relief to sectors such as traditional energy. Barclays' Cau suggests that the conservative shift may lead to a more relaxed green agenda.

Tougher Trade Policies

While the EU executive, maintaining a centrist stance, handles trade protections, a parliamentary shift could still wield influence. The EU's impending tariffs on Chinese electric vehicles could serve as a precursor to heightened trade barriers. According to Commerzbank’s Joerg Kraemer, the far-right surge may exacerbate trade frictions, potentially prompting retaliation from China, which would negatively impact European auto stocks and other sectors vulnerable to Chinese tariffs.

Defense Spending and Geopolitical Risks

The pressure to boost defense spending has escalated following Russia's invasion of Ukraine. Although defense budgets are primarily managed by individual EU states, there's a potential for joint EU funding aimed at defense efforts. The European bloc has floated the idea of a 100-billion-euro defense fund. However, far-right opposition to further fiscal integration may hinder these plans. Additionally, uncertainty looms over how these political shifts will affect European support for Ukraine, alongside other geopolitical uncertainties.