Investors have shunned French assets after political tensions flared up this week, betting the turbulent period is far from over.

S&P Global Ratings will update its assessment of France on Friday, adding to lingering uncertainty over the budget and the fate of the current government.

Outflows from the euro zone’s second-largest economy have pushed up its borrowing costs relative to peers and sent stocks tumbling, with the benchmark equity index on track for its worst year relative to European stocks since 2010. France’s benchmark bond yields were on par with those of Greece for the first time ever, the latest milestone in a week of growing anxiety over the fate of Prime Minister Michel Barnier’s government.

The yield on 10-year French government bonds, considered among the safest in the euro zone, briefly rose to 3.03 percent before retreating. That’s the same as the yield on similar bonds from Greece, the country at the center of Europe’s sovereign debt crisis.

“We could see something that triggers a more significant decline,” said Nicolas Simar, senior equity fund manager at Goldman Sachs Asset Management. “It’s hard to say we’ve hit the bottom.”

Investors, already wary of Europe because of the twin threats of U.S. trade tariffs and escalating tensions with Russia, are concerned about Barnier’s ability to pass next year’s budget. Now, France looks like the worst off, meaning any money allocated to Europe is likely to go elsewhere.

S&P downgraded France's credit rating from AA to AA- in May, highlighting the government's failure to meet planned targets to control the deficit. Barnier's proposed budget for next year includes key spending cuts, but Marine Le Pen of the far-right National Rally party has vowed to overthrow the government through a no-confidence motion if the party's demands are not met. Barnier is reportedly ready to adjust plans to increase electricity taxes, which Le Pen has criticized. She also called for changes to measures to curb pension spending and reduce state drug reimbursement.

Further action will depend on how the National Rally responds to the government’s budget proposals in the coming days and weeks. Barnier’s plan includes 60 billion euros ($63 billion) in spending cuts and tax increases aimed at reducing the country’s deficit to around 5% of GDP next year, from an estimated 6.1% of GDP in 2024.

Both Fitch Ratings and Moody's Ratings last month put France's ratings outlook on a negative note, citing deteriorating public finances and the political challenges of controlling a ballooning budget deficit.

International investors hold more than half of French government bonds, according to the Banque de France, and there are already signs that Japanese investors are dumping French debt and moving into other European bond markets. French bonds suffered their worst weekly outflows in more than two years in the five days through Tuesday, according to data compiled by BNY, the world’s largest custodian.

That has sent the yield gap between French and German bonds soaring to levels last seen during the euro zone sovereign debt crisis in 2012. In less than two weeks, the spread has surged by nearly 15 basis points.

“This is a sudden event — people think the budget is going to come out and look to the U.S.,” said Hank Calenti, senior fixed-income strategist at SMBC Nikko Capital Markets. “So this is a sell first, ask questions later moment.”

Matthieu de Clermont, head of insurance and regulatory strategy at Allianz Global Investors, said ratings agency downgrades were already largely priced into French assets, so S&P's latest rating might not trigger more selling.

“Overall, the market is under-allocated or playing with French risk, so we can expect that if this volatility occurs, some investors will come back and reinvest in the positions they sold,” he said.

He also noted that if the spread over German bonds widens to 100 basis points from 85 basis points now, investors may start buying French bonds again. Vincent Mortier, chief investment officer at Amundi SA, Europe's largest asset manager, holds the same view.

Equity investors such as Goldman Sachs’ Simard say the sell-off has created some picking opportunities for stock pickers in sectors such as technology and IT services, but companies such as utilities or telecoms that are tied to French borrowing costs are at risk of further turbulence.

The depressed mood also means France is increasingly being compared to countries such as Greece and Spain that were once at the center of Europe’s debt crisis. The gap between French and Italian yields has narrowed, shrinking by nearly half to about 40 basis points since September.

“The 2025 trade could be a move towards Italy,” said Axel Botte, head of market strategy at Ostrum Asset Management. “The focus is now on core bonds rather than periphery bonds because the fiscal trends in Spain, Portugal and even Italy are much better.”

“In the long term, France’s economic outlook is bleak,” said Michiel Tukker, senior rates strategist at ING Groep NV. “The weakness in the French economy will make the seemingly impossible task of fiscal consolidation more challenging.”

Article forwarded from: Jinshi Data