According to Citi, France's parliamentary elections have already caused a stir among investors as the country's risk premium rises. However, two possible scenarios have not yet been priced in by the markets and could impact share prices in the wider European region.
“Our model suggests that the market is pricing in something between a favorable outcome and a stalemate… not quite, but we are probably still a few percentage points away from fully pricing in the stalemate,” Beata Manthey, head the bank's global equity strategy, Friday on CNBC's “Squawk Box Europe.”
“However, the market is not priced in for a far-right or far-left majority,” Manthey said.
The tax and spending plans of both 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 for concern about future bond market volatility. Some economists have warned that if either were to form a majority and quickly push through a majority of their proposals, it could escalate into a debt crisis.
Both parties appear to be doing better than the centrist coalition with President Emmanuel Macron's Renaissance Party in the first round of voting on Sunday. However, the path after that seems very uncertain.
A favorable outcome from a market perspective could mean that the centrists find a way to win, or that a parliament emerges in which no party can implement its agenda.
Citi conducted a scenario analysis of different outcomes and what they could mean for Paris CAC-40 stock market index – also based on potential moves in the spread between French and German bond yields, which hit a 12-year high on Friday.
“The result is still unclear, we only have polls for the first round of the elections. So we will know a lot more on Sunday evening,” said Manthey.
“Let's put the election announcement in the context of investors' positioning. Europe has been a very hot market, has outperformed, international investors have shifted from the US to Europe, positioning has stretched or become net long. has been extended for a long time, especially for European banks. And that's all neutral now, but it's not negative,” she said.
European stocks are trading at a discount of almost 40% to U.S. equities, a “huge” gap compared with the historical average of around 15% to 20%, she said.
“But valuations need a trigger. The increased political risks are not a trigger, that's what I'm concerned about. … Our model right now suggests it's fairly priced for what analysts expect in terms of fundamentals,” she continued.
“Let's put it this way: we have downgraded Europe and upgraded the US, due to increased political risks. Within developed markets, European equities tend to be the most vulnerable to these changes,” she added.
If the French election result is 'very market unfriendly… markets in Europe are quite correlated [the] CAC is selling significantly, you have spillovers elsewhere as well,” Manthey said.
