Entente Misérable?

“It was the best of times, it was the worst of times…." (A Tale of Two Cities)

Britain and France seem to have more in common than usual at the moment, and not in a good way: unhappy voters, ineffective government, surging populist oppositions, disappointing economies, strained public budgets… There is talk of fiscal 'crisis', credit downgrades and soaring bond yields.

We can't offer reassurance about the politics.

President Macron has just named France's fourth prime minister to hold office in the last twelve months. Few would bet on the new, as-yet-to-be formed administration lasting much longer than its predecessors, and another set of parliamentary elections (which would be the third since mid-2022) might be in the offing. Protest and industrial unrest seem to be on the rise (again).

The immediate cause of the instability is the inability of the government to implement a tougher budget - which ultimately reflects the reluctance of the French population to accept longer working hours and greater labour market flexibility generally. Watching and waiting is Marine Le Pen's National Rally.

UK Prime Minister Starmer has a big majority, but his party is difficult to manage, and A Series of Unfortunate Events has eroded his authority. His government should be able to raise taxes in November, but has been unable to implement even a modest welfare reform.

The UK government's economic difficulties are partly self-made: it lacks savvy, and has bound itself to spuriously-precise and arbitrary fiscal rules (presided over by an unaccountable and overconfident invigilator). As in France, though, the electorate is unwilling to make difficult choices. In the wings here is Nigel Farage's Reform Party.

However: troubling politics need not translate into troubled economics and markets (we seem to be making this point rather a lot in recent times…).

Growth in both economies has been disappointing (the UK is slightly ahead, Brexit notwithstanding), but they are hardly alone in that. There is no reason to think both have gone permanently ex growth.

Market-wise, both French and UK MSCI indices have so far outperformed global stocks in common currency terms this year (the latter is as much a play on global as domestic business prospects anyway). Their bond markets have underperformed, but hardly dramatically: the 10-year yield spread to German bunds in each case has widened by less than a quarter of a percentage point (25bp).

This could change, of course. But a genuine 'crisis' is not inevitable in either case, and the countries' fiscal prospects are less one-sided than they are widely said to be.

For sure, the starting points do not look encouraging. Using comparable IMF data, their net debt to GDP ratios are around 100% (France's just above, the UK below), and their prospective deficits in 2025 might be around 5% of GDP (again, the UK's slightly lower, France's higher). The French government is the bigger, inasmuch as it spends the equivalent of almost three-fifths of GDP, the UK closer to two-fifths. The UK government faces a bigger interest bill, partly because of its greater use of index-linked bonds, whose coupons and principals are boosted by high RPI inflation. Nonetheless, 'debt spirals' can be avoided in each case, and in our opinion likely will be.

Government deficits, like any imbalance between two big numbers, are very sensitive to small changes in the growth rates of those numbers. As the differences compound, and cumulate as bigger or smaller debt levels, debt ratios can swing markedly – in both directions. All the attention of late has been on spending growth outpacing revenues, and on rising debt levels. But that scenario is not the only one – even in greying economies.

Looking beyond today's political stasis, retrenchment – when it comes – need not be huge. A positive gap of just half a percentage point per annum between the rate of growth in revenues and that in spending, if sustained, could deliver a big cut in both countries' debt ratios over a couple of decades. There is still everything to play for.

Which may help explain why those bond yields haven't risen more dramatically. We're not especially keen on bonds, but whether we like them or not is more likely to reflect the outlook for inflation and interest rates than governments' balance sheets – even those in France and the UK.

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