Rocking le bateau

The euro is already falling as the newly elected French President Francois Hollande enters the Elysée Palace. France’s election of a socialist candidate, who has stood firm on an anti-austerity, tax-and-spend platform, is widely seen as putting the increasingly fragile eurozone in real danger.

The French elections have been the strongest manifestation of a wider backlash against German-imposed austerity measures to date.

That said, many believe Hollande is unlikely to rock the boat as much as his campaign promises might suggest. France is no US, which has a captive and endless market for its government debt, and if it strays too far from its fiscal targets, it will find its cost of borrowing rises sharply.

It has already gone through the ignominy of losing its AAA-rating, but this would be an altogether more serious blow to its finances. Analysts at Fidelity predict that after a period of volatility in the run-up to parliamentary elections in mid-June, the dust will settle as Hollande gets down to business and navigates his significant policy constraints.

A similar political story has emerged from the weekend’s general election in Greece, with the two political parties that backed the bailout garnering just 34% of the vote between them. The various rescue packages saw Greece receive more than £200bn in aid, but forced it to agree to vast spending cuts that – according to Greek voters – were likely to exacerbate an already crippling recession. Greece’s exit from the eurozone now looks inevitable as it is impossible to reconcile popular resistance to austerity with the requirements for further bailouts.

The pattern is likely to be repeated across Europe as more countries go to the polls. Many will look across the pond and see that prioritising growth over austerity appears to be working in the US. However, the US dances to its own tune and eurozone economies are unlikely to see government bond buyers as forgiving if they adopt a higher-growth, lower-austerity target.

What is all this likely to mean for markets? In short, more volatility. The problems in the eurozone are well-known and understood. The impossibility of Greece’s task was clear, though the timing of its exit from the eurozone less so. As such, although this latest round of political problems has prompted a sell-off in markets, it is likely to be relatively short-lived as valuations do not look stretched and the corporate sector is in reasonable shape. It may be the final dance for the eurozone in its current guise, but a resolution is sorely needed. Markets may welcome this once the initial shock is over.

May 2012