French elections: “Don′t panique”; Turbulent times for Emerging Markets ahead

This week, we looked at the potential impact of the French election on the capital market. And we analyzed the sovereign debt sustainability in emerging markets, where the Ukraine war has amplified the pressures of financial tightening and slowing trade growth. We also have a new episode of our Tomorrow podcast for you focusing on what higher inflation means for central banks and monetary policy in the US and the Eurozone.

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French presidential elections: “Don’t panique!”

This weekend, the first round of the French presidential election will take place. We took look at the market implications. Our key takeaways:

• Is the market underestimating the risk of a surprise outcome in the French elections? Unlike 2017 the delicate phase for investors lies between the first and second round. A significant repricing of the political risk premium could occur in case we see (i) a massive shift in second-round voting intentions against incumbent Emmanuel Macron and/or (ii) a risk of massive abstention.
• Our base-case scenario is a victory of incumbent Emmanuel Macron with a repeat of the 2017 contest against Marine Le Pen in the second round. We expect some temporary spread widening for French government bonds (OAT) between both rounds round. However, a victory of an EU-skeptical candidate would carry longer lasting risks for both OAT and peripheral spreads.
• French government bonds’ semi-core status is not a given and will depend on France’s relative fiscal stance in the Eurozone. While the budget deficit doesn’t show noticeable improvement from the pre-Covid-19 years (-6.5% in 2021, -7% for in 2022) none of the candidates’ programs point to a consolidation course.

You can read the full report here.

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Emerging market sovereigns: turbulent times ahead?

The increasingly hawkish monetary stance of the US Fed and slowing global trade growth have raised concerns about sovereign risk in emerging markets.

• The terms of trade shock from the Ukraine war has amplified the pressures of financial tightening and slowing trade growth on sovereign debt sustainability in emerging markets. While capital accounts of most emerging market (EM) countries are crucially influenced by the US monetary stance, their current accounts are very much dependent on demand from China due to their upstream integration in global supply chains.
• The deteriorating debt service capacity (especially when compared to exports) will create problems for some countries but we do not expect a repeat of sovereign debt crises similar to the ones in the 1980s and 1990. Several (large) EM economies have become highly vulnerable to tighter financing conditions, including those in Emerging Europe (Hungary, Romania and Turkey) and Africa (Egypt, Kenya and Tunisia), as well as in Latin America (Argentina and Chile), albeit to a lesser extent.
• Under baseline conditions, we expect a broad-based but contained EM sovereign spread widening. In local currency terms, divergences between countries are as heterogeneous as inflationary pressures. Local currency yields will remain elevated in 2022, with a gradual reversal in 2023 as headwinds start to abate.
• Should our adverse scenario materialize, we expect the escalation of the war in Ukraine to cause a global recession with significantly higher inflation. Deteriorating EM fundamentals and generalized capital outflows would lead to a significant widening of hard currency spreads and higher local currency yields.

You will find our report here.

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Digital content

A fresh episode of our podcast ‘Tomorrow’: The invasion of Ukraine has sent energy prices surging, which means inflation is likely to remain higher and stickier in 2022. What does this mean for central banks and monetary policy in the US and Eurozone? We find out in this episode with Patrick Krizan and Katharina Uterm?hl, Senior Economists at Allianz.