Analysis-Political chaos leaves France sidelined as investors warm to Europe

By Yoruk Bahceli and Leigh Thomas

LONDON/AIX-EN-PROVENCE, France (Reuters) -France is missing out on the investor optimism that has defined Europe's markets this year, hamstrung by its strained public finances and political volatility that threatens to paralyse policy until at least 2027.

Global investors and French executives cite the risk that budget negotiations could trigger another government collapse in the autumn, while pessimism among French households is dragging on consumer spending and economic growth.

Centrist Prime Minister Francois Bayrou has faced eight no-confidence motions in parliament since taking office in December and his minority government is now struggling to find 40 billion euros ($47 billion) in spending cuts for the 2026 budget.

The contrast with neighbouring Germany, whose new government is preparing to loosen historically tight purse strings and pump billions into the economy through defence and infrastructure spending, could hardly be starker.

"While all the other highly indebted European countries - Greece, Portugal, Spain and Italy - have taken advantage of years of inflation to reduce their public debt ratio, France - whose deficit is now the highest in the euro zone - is increasingly diverging," said Pierre Moscovici, head of the Cour des Comptes public audit office and a former finance minister.

To narrow the budget gap, Bayrou will have to convince opposition parties to stomach spending cuts only slightly smaller than those proposed in the 2025 budget that brought down his predecessor.

OUT OF FAVOUR

Germany's historic embrace of looser fiscal policy and the impact of President Donald Trump's sometimes erratic policymaking on confidence in U.S. assets have given a boost to European financial markets and other investments this year.

A key beneficiary has been Italy, which has seen the risk premium paid on its 10-year debt compared to that of safe-haven Germany drop towards where it traded in 2010, before the euro zone debt crisis escalated.

But the 10-year risk premium paid by French debt over German is still at 70 basis points, well above levels of around 50 bps seen before French President Emmanuel Macron called a shock snap election last summer.

The French-Italian yield gap is meanwhile near all-time lows, even though Italy has a bigger debt pile.

Candriam's chief investment officer Nicolas Forest said he favoured German, Italian and Spanish bonds and was underweight France, a situation he called "completely unusual".

French stocks are missing out, too.

The blue-chip CAC 40 index trades below where it was before the election was called and is lagging Europe's STOXX 600 aggregate. The Paris index has returned just 5% this year, four times less than Germany's DAX.

Simon Blundell, co-head of fundamental European fixed income at BlackRock, the world's biggest investor, said he had no big positions in French debt and favoured Italian bonds, encouraged by political stability in Rome and declining volatility.

Even if France's government survives the autumn, investors expect the budget squeeze to underwhelm as a fix for fiscal strains and so fail to increase the appeal of French assets.

"Any compromise political parties find will be really temporary in terms of measures, and not great for debt reduction and deficit improvement," said Candriam's Forest. 

And even presidential and parliamentary elections in 2027 may not fully dispel the political uncertainty, if no party emerges dominant.

REAL ECONOMY BLUES

To prod opposition parties to back Bayrou's budget, Public Finances Minister Amélie de Montchalin has suggested France could turn to an IMF bailout if it does not decisively grip its finances.

Carrefour CEO Alexandre Bompard said such doomy talk only caused the French to save more, jeopardising a consumer spending recovery that he said was more fragile than in the supermarket giant's other European markets.

"If we have 5 percentage points more savings than other European countries, it's because we have an extraordinarily high level of political and fiscal uncertainty," Bompard told an economics conference in Aix-en-Provence on Friday.

With consumers hesitant to spend, French business activity has consistently lagged European peers this year, even though the private sector is less exposed to U.S. trade tensions than Germany or Italy's more export-focused economies.

"The economy is genuinely struggling, and you can see this in PMIs month after month where France is getting singled out for how weak it is," said Barclays' head of euro rates strategy Rohan Khanna, referring to the PMI surveys of company activity.

Since January, economists polled by Reuters have downgraded France's 2026 growth forecast to 1%, while Germany's has been upgraded twice, to 1.3%.

Brushing aside any prospect of IMF intervention to prop up France's public finances, the Fund's French chief economist Pierre-Olivier Gourinchas insisted Paris could no longer put off getting its fiscal house in order.

"France is not exempt from the laws of gravity, so we're going to have to adapt," Gourinchas said in Aix-en-Provence. "We can't fly, we're going to have to plan our landing and make spending cuts."

($1 = 0.8542 euros)

(Reporting by Yoruk Bahceli in London and Leigh Thomas in Aix-en-Provence, additional reporting by Dhara Ranasinghe, Dominique Patton and Mathieu Rosemain; Editing by Mark John and Catherine Evans)