The “Sword of Damocles” hangs high. French assets continue to be cold, and luxury stocks may usher in a turnaround

French assets continue to be deeply discounted, and French Prime Minister Francois Bayrou’s efforts to deal with the ongoing political crisis are far from enough to attract investors back. To change this situation, France needs to develop a concrete plan to reduce its huge budget deficit.

French assets took a hit more than six months ago when President Emmanuel Macron called an early election. France’s CAC 40 stock index has lagged behind other major European benchmarks this year, and the cost of insuring debt against default is rising. The extra yield on French bonds over German bonds is about 80 basis points, almost double what it was before the election. Meanwhile, trading activity in the French market has fallen sharply since August last year.

French stock market downturn

“There’s a sword of Damocles hanging over French stocks,” said Vincent Juvyns, global market strategist at JPMorgan Asset Management. He said markets were demanding action on the deficit and “there is an urgent need for the CAC 40 and European markets to remove these uncertainties and move forward with budget reforms” while restoring competitiveness.

Juvyns sees a “high probability” of a new French election in July and says the current 80 basis point spread between French and German government bonds is relatively low given the budget situation and political deadlock. He adds: “Ultimately 100 basis points is a more reasonable level given the current situation.”

Markets welcomed Bayrou’s recent announcement that the budget deficit would be kept at 5.4% of gross domestic product (GDP) in 2025, slightly higher than the previous government’s deficit plan. Bayrou plans to reduce the deficit to the EU’s 3% target by 2029, but investors are clearly skeptical. Meanwhile, Bayrou will face a no-confidence vote later on Thursday, which his government is likely to survive. With multiple votes likely in the coming weeks, Bayrou has been actively negotiating with the parties to avoid the same fate as his predecessor.

The tough times of the past few months have not changed blue-chip valuations much, with the CAC 40 index trading at 13.5 times expected earnings, roughly in line with its long-term average and in line with the benchmark Stoxx Europe 600 index. By contrast, a basket of stocks tracked by Goldman Sachs Group Inc. focused on France’s domestic economy now trades at less than eight times expected earnings, the lowest in more than two years.

Arnaud Girod, head of economics and cross-asset strategy at Kepler Cheuvreux, said: “Stocks related to the French economy are too cheap, but there is no point buying them as long as political risks are high. The rest of the French stock market is dominated by luxury stocks, which we are neutral on given the trade war situation.”

Investors have a broadly similar attitude toward all French stocks. The CAC 40, which generates only 15% of its revenue in France, has a poor yield spread. French politics aside, the CAC 40 may have other problems, as its companies are heavily dependent on uncertain global economic growth. Consumer discretionary and industrial stocks make up more than 50% of the benchmark. Luxury goods and cosmetics stocks, including LVMH, Hermès, Kering and L’Oréal, account for about 20% of the CAC index’s weighting. However, French luxury stocks may see a turnaround after Swiss luxury goods company Richemont reported better-than-expected third-quarter sales earlier, sending its shares up 14%.

“French equities have underperformed since the start of the year and the risk discount remains, but we do not expect it to widen unless a new political crisis emerges,” said Benjamin Melman, chief investment officer at Edmond de Rothschild Asset Management. “The French government has changed its strategy compared to the previous one, which could provide some sustainability and longer political life expectancy. That said, visibility remains low,” he said.