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Sylvain Goyon, Stephen Ausseur and Benoit Peloille, cash equities strategists, Natixis

Should you be underweight the French market in 2013?

Natixis cash equity strategists Sylvain Goyon, Stephen Ausseur and Benoit Peloille (pictured) argue that France’s failure to address much-needed structural changes, and its reliance on higher taxation to bring down its budget deficit, could have a knock-on effect upon the country’s stock market that would depress equity prices by as much as 20 per cent…

Leading economists and commentators fear that France’s budget for 2013 will have a significantly negative impact on the country’s economic growth. Having previously forecast growth of 0.7 per cent this year, Natixis economists now predict a contraction of 0.4 per cent, with the public deficit shrinking by just 1.1 per cent of GDP.

This means France will not meet its deficit reduction target of 3 per cent for 2013. But of even more concern, it means a real risk of a vicious circle taking shape in a similar way as in Italy and Spain. It starts with budget austerity and a shrinking economy, and leads to lower tax revenues, a worsening deficit, a wary market, further austerity measures, and a further decline in economic growth.

Indeed, unless major structural changes are introduced to improve competitiveness and reform the job market, and without a shift in European policy to spread budget consolidation efforts over a longer period of time, there is a strong possibility of a peripheral Europe-style scenario in the stock market in 2013, bringing falls of up to 20 per cent in the value of French equities.

Unveiled on September 28, France’s draft budget had the chief aim of reducing the public deficit by an unprecedented 1.5 per cent of GDP next year, bringing it down to the EU-stipulated maximum of 3 per cent of GDP. Most notably, the bill sought to raise an extra EUR26bn in tax revenues: EUR6bn from the amended 2012 Finance Law, EUR10bn from extra taxes on households, and EUR10bn from extra taxes on businesses, combined with just EUR10bn in spending cuts, about which little information has yet been published. 

Consolidating a budget by raising taxes rather than by cutting spending is a typically French strategy and – as Natixis’ chief economist, Patrick Artus, has pointed out – it is usually ineffective. Countries that have taken this approach in the past (notably France, Japan and Portugal) have ended up with minimal deficit reduction, flat unemployment and reduced investment by businesses.

Spending cuts, on the other hand, have historically proved effective at balancing budgets. Several countries took this approach successfully in the early 1990s, including Canada, Spain, Italy, the US, Sweden and Finland. This is because spending cuts lower household savings rates, thereby boosting consumer spending, and encourage businesses to invest.

Assuming France’s 2013 budget does indeed have a major recessionary impact on the economy, there is a risk that investors will apply a risk premium to the French stock market, similar to those currently applied in Italy and Spain.

As an indication, the French and Dutch equity markets saw their political discounts widen in September. While an increased political risk premium can be easily explained in the Netherlands, which held national elections in that month amid concerns about anti-European sentiment, it is much more worrying for France. It points to investor expectations of a massive economic slowdown, deterioration in France’s sovereign debt and contagion in its corporate sector.

To estimate the potential impact of such a scenario on the French stock market, there are two key metrics to consider: changes in credit default swap spreads on government bonds, which act as a proxy for the country’s political risk premium, and sensitivity of the stock market to variations in the five-year sovereign CDS.

During recent periods of economic pressure, for instance from September 2008 to March 2009 and during the whole of 2011, CDS spreads on French government bonds widened by 85 and 135 basis points respectively. In both these cases, there was a close correlation between French stock market indices and the country’s CDS spreads, with large caps showing slightly more sensitivity than midcaps.

If we assume that CDS spreads return to their December 2011 levels of 100bps above current levels, the historical correlation with stock indices would point to the French market dropping by almost 20 per cent. The worst performing sectors will be those most closely correlated with France’s five-year CDS – banking, utilities, financial services, transport, insurance and automotive – while pharmaceuticals, beverages, non-food retail, oil, aerospace and defence, and luxury would be most immune.

Sovereign CDS spreads of this nature would also cause France’s political risk premium to inflate, and there are already signs of this. The political discount for France – the portion of stock market performance not accounted for by economic growth, which began to emerge on July 21, the date of Greece’s second bailout – would rapidly return to its peak level of 20 per cent from 3 per cent currently.

This is the same political discount investors currently apply to Spain and Italy. In other words, the market would put exactly the same pressure on France as on peripheral countries to introduce the necessary structural reforms currently missing from the government’s programme.

Meanwhile, as a result of the budget, Natixis’ economists also expect private consumption in France to fall 0.6 per cent in 2013 and 0.2 per cent the following year, following a fall of 0.1 per cent in 2012. This multi-year decline is unprecedented in France, where consumption has shrunk in only one year (1993) since 1950.

Any further deterioration, for instance if unemployment deteriorates more than expected would hit midcaps in particular. The sectors most penalised by a decline in private consumption would be food, capital goods, food retail, real estate, telecoms, transport and, to a lesser extent, media, although the remaining sectors are largely insensitive to this factor. 

If you match dependency on private consumption with sensitivity to CDS markets, you end up with a list of seven stocks to avoid: ADP, Air France, AXA, CNP Assurances, CASA, Société Générale and TF1.

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