Why France didn't sink

Three areas that investors should be aware of in our weekly market update:

1. France may have found itself in the eye of the storm, but it is not close to defaulting.
2. ΟΑΤ (the French bond) yields actually fell (prices rose) after the French government collapsed.
3. As inflation, growth and interest rate expectations rose after the US election, the bond market became slightly more volatile, sending warning messages to governments (not only France) not to sacrifice too much stability on the altar of politics. 

If failing to balance a budget and agree in parliament caused debt crises, then the financial system would not exist and we’d be back to bartering. France doesn’t have a solvency issue, like Argentina or Greece had, so it will not likely default anytime soon. But as inflation, growth and interest rate expectations rose after the US election, the bond market became slightly more volatile, sending warning messages to governments (not only France) not to sacrifice too much stability on the altar of politics.

Week ahead

The week ahead is an important one from an economic perspective. It is interesting to see how markets are going to react (if at all) to the President-Elect’s comments on not attacking the Federal Reserve. In the US, the inflation number (Consumer Price Index is expected at 2.7% per annum) could be crucial in solidifying expectations towards one final rate cut in December. Later in the week, the European Central Bank is expected to lower its basic interest rate by 0.25%. Trade data out of Germany will also be interesting. 

Last week was mostly a French story. The collapse of Michel Barnier’s government (and the reluctance of others to step up in what is a very difficult parliament) after the failure to pass a budget, has been the centrepiece of financial news in the past few days.

Yields going up, reaching a 0.9% spread versus Germany, triple the average and a post-Euro-crisis record, and briefly touching Greece’s, sparked speculation that bond markets were attacking France, and putting the country in trouble.

Is France in danger? Is the UK in danger after an expansive budget?

Let’s take a step back.

Bond markets are far more important than equity markets (although by now slightly smaller overall). They are the place of preference for countries and companies to fund themselves. Organisations and countries that feel they can repay their debts would usually prefer to borrow, especially if inflation and interest rates are low. The most usual alternative for companies is to dilute ownership and issue equity, either public or privately. Countries can print money to pay their obligations (by issuing debt and telling the central bank to buy), but ultimately this is inflationary, and persistent inflation isn’t generally good for government stability. That’s why it is preferable to have independent central banks with inflation mandates (more about that next year).

Within portfolios, bonds (‘fixed income’) are usually the least volatile and most predictable part of assets. Holding to maturity, and assuming no default, an investor knows exactly what they will get in nominal terms (not real, as real returns are subject to inflation). Arguably, the US 10-year Treasury is the bedrock of the global financial system. 

This is a long-winded way to say that the good operation of bond markets is central to the global economic and financial system. They are also essential for politics. Calm markets allow countries to borrow at acceptable rates to refinance their debt. The more they remain calm, the more room political operators have to make promises, and the more room policymakers have to implement them. Conversely, volatile bond markets can cause significant political damage, as voters may see ‘bad’ decisions possibly costing access to financial markets. In late 2022 Liz Truss announced a surprisingly expansive budget, which sank her government in days. What was construed as a bad decision (fiscal expansion with high debt) was actually more bad timing. Bond volatility had already been going up precipitously, as markets were trying to catch up with the Fed hiking rates. At the time of the mini-budget debacle, volatility was up at 2008 and pandemic levels. So it didn’t take much for the bond market to react to an expansive budget.

Conversely, present bond volatility is about average. This is why ΟΑΤ (the French bond) yields actually fell after the French government collapsed. The spread vs Germany was up about 0.6%, and Credit Default Swap spreads rose from 25 to 40 (it takes over 200 against average to cause concern) so it was really just jitters.

And this is the whole point. Before the twentieth century, governments used to default often. However, the modern bond market and faster information systems meant that serial defaulters could easily lose access to financial markets, as their default can become a perennial theme. 

In the past 50 years, it is not G7 or other big governments (with the exception of Russia), that have defaulted.

Greece and Argentina remain by far the biggest defaulters in absolute terms since 1983.

Despite the constant debt buildup, big countries don’t get into debt crises easily. If failing to balance a budget and agree in parliament caused debt crises, then the financial system would not exist and we’d be back to bartering.

France doesn’t have a solvency issue, like Argentina or Greece had, so it will not likely default anytime soon. But as inflation, growth and interest rate expectations rose after the US election, the bond market became slightly more volatile, sending warning messages to governments (not only France) not to sacrifice too much stability on the altar of politics.

George Lagarias – Chief Economist

Market update

Markets ‘climbed a wall of worry’ last week, as global equities rose by +0.9% in the face of significant political disruptions. European stocks were unfazed by the collapse of the French government, rising by +1.8%, as markets welcomed the prospect of less uncertainty going forward. Interest rate expectations also drove sentiment, as a stronger consensus formed among traders that the Federal Reserve would cut rates by 25 basis points at its 18 December meeting. From Friday 29 November to Friday 6 December, the implied probability priced in by futures markets of a 0.25% rate cut (as opposed to keeping rates steady) increased from 52% to 86% (according to CME FedWatch). US equities generally responded positively to the data releases of the week, rising +1.0% to new all-time highs. Growth stocks, which are more sensitive to interest rate policy, outperformed value stocks in the US. Emerging markets also performed well, rising +2.2% in GBP terms, as strong returns from China stocks offset a -1% (local currency) fall in South Korean stocks in response to the unexpected declaration of martial law by the president and subsequent events over the week.

Bond yields moved modestly over the week, with the US 10-year rising three basis points, UK 10-year gilt yields rising by four basis points, and German 10-year bund yields rising by two basis points. French 10-year OAT yields fell by just one basis point amid the political turmoil (bond prices and yields move in opposite directions).

Macro news

Non-farm payrolls in the US rose by 227,000 in November following an upwardly revised 36,000 gain in October, a month that had been affected by storms and strikes. The unemployment rate increased slightly to 4.2%, while average hourly earnings were slightly ahead of estimates at 0.4% versus 0.3% expected.

The US manufacturing PMI for November was 48.4%, a number which represents a contraction in the US manufacturing sector (figures below 50 indicate a contraction). The number was slightly better than the previous month, which had a reading of 46.5%, and also beat economist expectations of 47.5%.

The US services PMI was 52.1% in November, down from 56% in October, indicating a slowing rate of growth in the US services sector. The number was slightly worse than economist expectations of 55.5%.