News of the week summary - 06/16/2024

French markets shook by uncertainty over new elections' outcome 

French stocks have experienced a significant decline amid mounting fears of a populist surge in the upcoming parliamentary elections (taking place June 30 and July 7), unexpectedly announced by President Macron. The CAC 40 index has plummeted over 6% in just five trading sessions, erasing €150 billion from its value, marking the worst week since March 2022. The announcement of snap elections has brought concerns that both the far-right Rassemblement National (RN) and a left-wing coalition could undermine Macron's centrist alliance. 

Le Pen's populist policies, such as tax cuts and lowering the retirement age, while appealing in opposition, could pose severe fiscal challenges if implemented. Analysts predict that these policies could significantly increase France's deficit, with estimates suggesting an annual deficit increase of 3.9 percentage points. Investors are particularly worried about the RN's protectionist stance and its costly spending plans, which could strain public finances already stretched by pandemic and energy crisis expenditures.

The spread between French and German government borrowing costs has widened, indicating increased risk perceived by investors. The CAC 40's drop was led by sharp declines in banking stocks, reflecting broader concerns about economic stability, as banks' profits heavily depend on economic conditions.

The election uncertainty has not only affected French stocks but has also led to declines in other European markets. The Stoxx Europe 600 index (tracking the 600 European Companies with the biggest market values) recorded its worst week since October, with major indices in Germany, Italy, and Spain also falling. The euro weakened against the dollar, further highlighting market instability.

Despite the RN's attempts to moderate some of its more extreme economic proposals, concerns remain about the feasibility and funding of its plans. Macron's government has focused on highlighting the potential economic risks of an RN-led administration, emphasizing the potential for increased debt and fiscal instability.

Biden administration in limbo amid uncertainty over the Fed's policy 

The Federal Reserve’s latest signals have introduced uncertainty into the economic landscape, impacting both President Joe Biden's administration and prospective homeowners. Contrary to earlier expectations, the Fed indicated that borrowing costs would not decrease significantly this year. This development came as a surprise, especially after a decline in May's consumer price index (CPI). The unexpected drop in US inflation to 3.3% had fueled market optimism for early interest rate cuts before the November election, prompting the S&P 500 to climb by 1.3% in a day.

The Fed later revealed a more conservative outlook than expected, suggesting only a single quarter-point cut in 2024. This cautious stance is based on ongoing inflation concerns, with the Fed holding rates at a 23-year high of 5.25-5.5%. This scenario implies that significant rate cuts might not occur until after the November election, which could impact Biden’s approval ratings, especially regarding his handling of the economy. Fed Chair Jay Powell nonetheless left room for interpretation, acknowledging that the projections were not set in stone and emphasizing the need for more data.

High borrowing costs remain a contentious issue, especially for young people and potential homeowners, who face increased difficulties due to elevated mortgage rates. While the Biden administration has refrained from publicly pressuring the Fed, Democratic senators have voiced concerns about the impact of high rates on housing costs. Powell noted that reducing inflation was crucial to lowering interest rates and alleviating housing market pressures.

The resilience of the US economy complicates the Fed’s task. Despite the high rates, economic activity has not slowed as much as expected, making it unclear whether inflation will continue to decrease or if unemployment will rise sufficiently to justify earlier rate cuts. This situation leaves the Fed in a data-dependent stance, with the possibility of rate cuts remaining open for September, but not guaranteed.

US increases sanctions on Russian financial institutions

The US Treasury has significantly expanded its sanctions on Russia, now targeting any foreign financial institution that transacts with a sanctioned Russian entity. This move broadens a previous executive order from December, which authorized sanctions on institutions acting on behalf of around 1,200 Russian entities. The new measures increase this number to over 4,500.

In response to these expanded sanctions, Russia's main stock exchange, the Moscow Exchange, has suspended trading in dollars and euros. The sanctions were designed to sever the remaining links between the Russian financial system and foreign banks, complicating the pricing and convertibility of the ruble. The Russian central bank has stated that exchange rates will now reflect interbank transactions, increasing opacity and costs for importers and exporters.

The new US measures aim to limit Russia’s access to foreign technology, equipment, software, and IT services, thereby diminishing its capacity to sustain its military operations in Ukraine. Treasury Secretary Janet Yellen emphasized that these sanctions are intended to close avenues for evasion and increase the risks for financial institutions dealing with Russia’s war economy.

The announcement of these sanctions has led to volatility in the Russian market. Analysts predict a decline in the ruble’s value by 3 to 5 percent in the coming days. The spread between buying and selling prices for the dollar at Sberbank, Russia’s largest state-backed lender, has more than doubled, and similar trends are seen for the euro. This increased cost and decreased transparency will likely hamper the ease of currency transactions and heighten economic uncertainty within Russia.

To mitigate the impact, Russia has been shifting towards using the Chinese renminbi for foreign currency transactions. In May, the renminbi accounted for over 50% of foreign currency trading in Russia, surpassing the combined share of the dollar and euro. However, Chinese banks are increasingly cautious due to the threat of secondary sanctions, leading to a shortage of renminbi liquidity—a risk identified by the Russian central bank.

Index provider MSCI excludes EU bonds from its sovereign indices

Bonds issued by the European Union experienced a decline after MSCI announced they would not be included in its sovereign bond indices. A financial index is a measurement of the value of a section of the financial market, typically represented by a weighted average of selected stocks or other securities. 

MSCI's announcement surprised many investors who had expected inclusion. This decision has raised concerns that other index providers might follow suit, and is a setback for Brussels' objective to establish EU bonds as mainstream government debt. The yield on the EU's benchmark 10-year bonds, which moves inversely to their prices, increased by 0.06 percentage points after the announcement.

Since the launch of the €750 billion NextGenerationEU program in 2021, the EU has been advocating for its bonds to be reclassified from "supranational" to "sovereign" status. This reclassification would potentially lower borrowing costs by aligning the bonds with those of individual member states. ICE, another index provider, is set to announce its decision on the inclusion of EU bonds in its sovereign indices in August. Analysts believe that inclusion in other indices could lead to significant investment flows. Currently, the EU's 10-year bond yield is 3.12%, higher than Germany’s 2.55%, despite both having a triple-A credit rating from two leading agencies.

The EU’s total debt has reached about €500 billion, ranking it as the sixth-largest in the Eurozone, following France, Italy, Germany, Spain, and Belgium. While MSCI plans to revisit its decision in the second quarter of 2025, analysts remain hopeful that EU debt will eventually be included in sovereign bond indices.

ECB says it might keep borrowing costs steady

ECB President Christine Lagarde indicated that the bank might keep interest rates unchanged for multiple meetings, even after initiating the first rate cut in nearly five years. This statement dampens expectations of continuous rate reductions following last week's quarter-percentage-point cut in the deposit rate to 3.75%.

Lagarde's stressed that the ECB is not committed to a linear path of rate cuts and could pause to assess labor costs and earnings trends. This flexible stance suggests that the ECB might not cut rates again at its next meeting on July 18, as new quarterly wage data won't be available until after that date.

The ECB's recent rate cut contrasts with the policies of the US Federal Reserve and the Bank of England, which are expected to maintain current rates due to persistent inflation. The ECB's move has surprised some analysts, given the Eurozone's recovering economy, rising inflation, and increasing wages.

Eurozone inflation increased from 2.4% in April to 2.6% in May, leading the ECB to revise its inflation forecasts upwards for the next two years. Despite this, Lagarde defended the rate cut as appropriate, citing sufficient progress in reducing inflation. She noted that the ECB would maintain restrictive rates to curb economic demand until inflation reaches the 2% target, anticipated by late next year.

The ECB president also affirmed that the ECB has not concluded its tightening cycle, aiming to control inflation through higher interest rates for an extended period. She pointed to rising labor costs, higher corporate profits, and declining productivity as factors exerting price pressures, which the ECB needs to monitor closely.