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German blue-chip stocks show more promise than their French counterparts, Barclays' strategists wrote in a note Friday, saying France has weak "long-term fiscal and growth fundamentals" and a looming risk of bond vigilantes sweeping in.
The euro zone's two biggest economies are both struggling. Germany is battling an ongoing manufacturing downturn that has turned it into the bloc's growth laggard, while disputes over its budget and long-term fiscal strategy caused its government to collapse earlier this month.
However, French borrowing costs have climbed above Germany's this year as political instability in the country spooked markets.
France is staring down years of potential political uncertainty, given its fiercely divided parliament in which no party or faction has a majority. There are also investor concerns over whether it can reduce its hefty debt pile and avoid credit rating downgrades.
A key question is whether French Prime Minister Michel Barnier's fragile government can pass the budget proposed in October — which includes significant public spending cuts and 60 billion euros ($65.6 billion) in tax hikes — or whether it will be toppled in a no-confidence vote beforehand.
"Compromise on the French budget remains possible. But any relief may be short-lived. There is no easy solution to the political impasse, while long-term fiscal and growth fundamentals remain poor," Barclays strategists said Friday, adding they maintain their preference for Frankfurt's DAX stock index over Paris's CAC 40.
France's left-wing New Popular Front alliance has said it will table a vote of no confidence if Barnier tries to force through the budget — so the government may need to make concessions to the far-right National Rally party in order to pass the motion.
Doing so "would arguably be a relief given the high-risk premium embedded in French assets," the Barclays' strategists continued, potentially pushing the spread — the difference in yield between two bonds — between German and French government debt from around 84 basis points currently to their 70-to-75-basis-point range of the past few months. This would likely boost the CAC stock market index by between 2% and 3%, they said.
However, if the government falls, that spread could widen toward 100 basis points and drive the CAC down by between 4% and 5%, they warned, and "bond vigilantes would likely step in the event of no stable government forming" or if the budget fails to pass.
The term "bond vigilantes" refers to bond market investors who protest against monetary or fiscal policy they don't like by selling bonds, thereby increasing borrowing costs for the government.
It comes after French borrowing costs drew level with Greece's for the first time on record this week. The fact that investors are demanding the same interest for holding French bonds as for that of historically unstable Greece — which has enacted sweeping market-friendly reforms since the sovereign debt crisis of the late 2000s — was seen as a significant milestone.
French risk premium had already risen in the run-up to its summer election, with the specter of an outright victory by the far-right or left sparking nerves over populist fiscal policy that could fail to address debt concerns.
CAC 40 index performance.
Beyond the short-term budget debate, Barclays found medium-term risk asymmetry was "not great" for French markets, and that "concerns about political instability and long-term fiscal trajectory may persist."
Barclays said that any knock-on impact on the euro area will be limited, however.
Jane Foley, senior FX strategist at Rabobank, is not convinced.
"There is a risk that a worsening in the political and budget outcomes in France could spark contagion through the euro zone. This would be reflected in rising bond yields and in a weaker [euro]," she said in a note Thursday.
"This risk is dependent on the budgetary and political stability elsewhere in the region. Germany's debt and deficit position is in better shape. That said, the country is facing severe structural issues that may require more government investment. There is also the prospect of a snap election early next year, the outcome of which could determine whether the country's debt brake is lifted."
"In the meantime, the euro zone is lacking strong leadership in both Germany and in France," Foley added.
— CNBC's Holly Ellyatt contributed to this story.
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