After a period of relative calm during the Olympics, the risks weighing on French stocks are again on the rise.

The CAC 40 Index is trailing the continent’s major markets, up less than 1% this year even as benchmarks including Italy’s FTSE MIB, Spain’s IBEX and Germany’s DAX post double-digit returns. Political gridlock is dragging on in Paris, fuelling concern that the country will fail to tackle its budget and economic challenges. French bonds and stocks are struggling and the cost of insurance against default is rising.

“The risk of a French fiscal crisis in the near-term is real,” said Charles-Henry Monchau, chief investment officer at Banque SYZ in Geneva. “French assets thus need to be traded cautiously in the coming weeks.”

Monchau added that there’s an elevated risk of social unrest because of the political fight over the formation of a new government, but the core scenario of a centre-right coalition would be rather positive for French bonds and stocks.

President Emmanuel Macron, who shocked markets by ordering a snap election after his party lost European Parliament elections in June, has been meeting with political representatives over the past days to find the next prime minister. But talks - already delayed by the Olympics - are difficult as parties ranging from the far-left to centre-right vie for power.  

“Political discussions drag on and political uncertainty grows,” CIC Market Solutions economist Benoit Rodriguez wrote in a note on Tuesday. “Given the division of the National Assembly into three blocs, uncertainty over the trajectory of public finances remains.”

Rodriguez notes that the government will need to table the 2025 budget bill in parliament by Oct 1. It will also have to submit a multi-annual fiscal plan to the European Commission on Sept 20 as part of an excessive deficit procedure initiated against France. Regardless of who will run the next cabinet, the diverse coalition is set to have limited room to reduce the budget deficit.Besides politics, French earnings have also turned into headwinds. In fact, global demand - which is responsible for the majority of revenues of French firms - has been an even bigger drag than politics, with luxury goods and consumer stocks turning into major underperformers. LVMH and L’Oreal SA are mostly responsible for the CAC’s recent weakness, due to their reliance on demand from China. That said, profit trends may be stabilising as seen in the chart below. 

Luxury companies reported flat revenue in the second quarter and their first-half profit margin implies a 12% year-on-year earnings decline, according to Bank of America Corp analysts, including Ashley Wallace. “2024 consensus estimates have come down 5% since May, and share prices underperformed the market by 9% over the same time period,” she wrote in a note. 

One silver lining comes from positioning, which has become less negative on France in the past two months, according to the Bank of America fund manager survey, with the proportion of investors looking to underweight the country dropping. Yet, it remains a net underweight for asset managers, the survey shows. 

Since the snap election announcement, the valuation premium that French stocks had enjoyed all of last year over other European markets has vanished. While risks for the broader European bloc are now more balanced, France remains a specific case. Domestic stocks - including banks and other stocks sensitive to policy decisions - are also still trailing. 

“The political risk is still there for French equities but I think the market considers it localised instead of a full-blown political crisis,” said Bloomberg Intelligence analyst Kaidi Meng. “The one sector still feeling the burn of the French election is the French banks,” she said, while, luxury goods and other consumer-related firms are weighed down by “demand headwinds”.

  - Bloomberg