France elections: reinforcing the higher bond yield regime

France's political uncertainty will likely manifest for the insurance sector primarily through sovereign bond market developments. With France's deficit risks extending out to the medium term, we do not expect the current uncertainty risk premium on French bonds to fully unwind. We also see underappreciated upward risk to German sovereign yields amid risks of less fiscal consolidation at European Union level over the coming years. Still, a higher bond yield regime is a positive tailwind for insurance asset portfolios. 

• Sovereign bond markets, the primary channel of France's heightened policy uncertainty to European insurers, have placed an uncertainty premium on France that we see persisting.
• We also see underappreciated upward risks to German sovereign bonds due to wider Europe likely becoming increasingly entrenched in the global paradigm shift of greater debt and deficits.
• A higher sovereign bond yield environment is a positive tailwind for insurance portfolios and duration-matched ALM could allow insurers to weather near-term volatility.

Sovereign bond markets are the primary channel by which European insurers will likely feel the repercussions of France's recent legislative elections. The key signposts for bond markets will be the new government's influence on the fiscal deficit trajectory and France's sovereign credit ratings, after S&P's downgrade in May.¹ Markets have shown recent relief that a lack of absolute majority for either the far left or far right removes the tail risk of radical, unfunded fiscal policy. However, the current hung parliament also poses risks as it could lead to several different scenarios (see Table 1), yet all result in a similar outcome of temporary policy standstill and, in our view, subsequently less fiscal deficit reduction from the incoming government compared with the old.

Table 1:  France's potential government scenarios

This pushes out uncertainty and risks to the medium-term and warrants the current embedded risk premia in French sovereign bonds (OATs). We see the spread of 10-year OAT yields over 10-year German bond (Bund) yields trading in a range of 55-80bps under this hung parliament, thus not compressing to pre-election announcement spread levels of <50bps. Importantly, we do not expect OAT-Bund spread widening beyond the 2017 presidential election levels when the potential risk scenario outcomes (e.g. "Frexit") were more consequential (see Figure 1).

Figure 1. 10-year OAT-Bund yield spreads before and after key events

In our view, France will remain politically uncertain for the foreseeable future. A grand coalition scenario between the centre and moderate left parties would be vulnerable to their policy differences. Alternatively, a minority government would be inherently rocky and repeated political gridlocks would leave the government ill-equipped to respond to the EU's recently opened Excessive Deficit Procedure (EDP)². A "technocratic government" would be a third temporary solution, but remains at risk of being dissolved as soon as mid-2025 when new legislative elections can be called. All these scenarios are vulnerable to a vote of non-confidence that could add renewed financial market volatility in the medium-term. 

Figure 2. General government debt (% of GDP) of France and Germany, and 10-year OAT-Bund spread

Less fiscal retrenchment under a gridlocked government and potentially even non-compliance with the EU's EDP point to French sovereign bonds staying in a higher yield regime over the medium term. Failure to comply with the EDP would block France's eligibility in the European Central Bank (ECB)'s financial stability tool, the Transmission Protection Instrument (TPI). The TPI is used to counter unwarranted disorderly market dynamics. While the ECB maintains ultimate discretion to step in markets if significant contagion risks were to materialise in a financial stress event, the bar for ECB intervention is likely higher.

We also see risks around our baseline bond yield forecasts skewed to the upside for broader European yields. Less fiscal consolidation and further sovereign credit rating downgrades in France could be the start of the watering down of credit quality of traditional "core" country European bonds (vs. "peripheral" countries like Italy). This could have spillover implications for the safe-haven status of German bonds – the ultimate "core" bonds – although up to now we see their relatively lower yield premiums justified due to Germany's still stronger credit fundamentals (see Figure 2).

However, in the medium term there is a threat of some potential fiscal slippage from Germany too, particularly if the upcoming US election triggers a President Trump scenario that places pressure on Germany and wider Europe to increase its defence spending.

While countries will still be constrained in their spending on the national level, such a geopolitical scenario could trigger the launch of another EU-wide fiscal facility, similar to the Next Generation EU Fund (NGEU), to address structural public investment spending needs for Europe. This could ultimately revive the debate over debt mutualisation in the medium term and add an upward drift to European bond yields more broadly. It would also complicate the backdrop for the ECB if EU-wide fiscal loosening adds to inflationary pressure, limiting its ability to cut policy interest rates over the longer term. 

On a broad level, insurance companies can benefit from a higher bond yield environment through their investment portfolios. Higher short-term bond yield volatility should not be as significant a concern for insurance companies if they are duration matched in their asset liability management. However, potential further sovereign rating downgrades are a risk to watch and the higher interest rate regime can have some indirect repercussions too for specific lines of business. For example, higher yields would lead to more expensive mortgages for French households, narrowing a common entry point for the sale of life insurance protection products. Political paralysis could weigh on the French real economy through weaker consumer and investor confidence, or drive saving policyholders to transfer wealth to other jurisdictions, triggering lapses.

In an extreme event, mass lapses could potentially lead France's insurance market supervisor to trigger the "Loi Sapin 2", which allows the Haut Conseil de Stabilité Financière (HCSF) – the financial system watchdog – to temporarily suspend redemption activity on financial stability grounds.³ Yet, this would also raise reputational risks that could weaken consumers' trust in the sector.