How a hung parliament in France could impact financial markets

• Citi analysts cautioned that the French election may not be as optimistically viewed by stock markets before the second round vote.
• If no single party gains an absolute majority, uncertainty will persist, according to analysts at Daiwa Capital Markets.
• The European Commission recently declared that France would be subject to an Excessive Deficit Procedure due to its challenging fiscal situation.

On Sunday evening, the initial indications for the French parliamentary run-off vote revealed some unexpected results, prompting political analysts to consider the possibility of a "hung parliament" situation that could pose difficulties for both policy-making and financial markets.

The New Popular Front coalition in France's upcoming election is projected to win the most seats, with President Emmanuel Macron's Ensemble party and allies in second place and the far-right Rassemblement National in third. However, none of the groups are expected to achieve an absolute majority of 289 seats, which could lead to gridlock in the coming weeks.

Citi analysts cautioned that stock markets may be overly optimistic about the French election and that a deadlock outcome could result in equity market valuations being 5-20% lower.

Our research shows that French equities tend to be more volatile than peers' around elections. This, combined with the fact that a 10% move in French equities is usually accompanied by an 8% move by the overall market, could indicate additional choppiness in the future.

Daiwa Capital Markets analysts discussed the possibility of uncertainty if no single party gained an absolute majority in a research note earlier this week. They mentioned that a grand coalition of moderate left and center parties, a unity government, or a minority government were all feasible outcomes.

The analysts predicted that the uncertainty about the future of French policymaking will persist.

Concerns on spending

The tax and spending proposals of the left-wing New Popular Front and the hard-right Rassemblement National (RN, or National Rally) party have been a major source of worry since the election was called.

The European Commission has announced that France will be placed under an Excessive Deficit Procedure due to its inability to maintain a budget deficit of less than 3% of its GDP. An EDP is a measure taken by the European Commission against any EU member state that exceeds the budgetary deficit limit or fails to reduce their debts.

The fractious parliament will make it challenging for any government to implement the budget cuts required for France to adhere to the EU's budget guidelines and maintain a sustainable public debt trajectory, as stated by Jack Allen-Reynolds, the deputy chief euro zone economist at Capital Economics, following the release of the exit polls.

The likelihood of France's government and other countries' governments disagreeing with the EU on fiscal policy has intensified due to the reinstatement of the bloc's budget rules and the impending implementation of Excessive Deficit Procedures for several countries, including France and Italy.

Bond rout

In recent weeks, France's bond market has seen an increase in jitters, with the premium on the country's borrowing costs compared to those of Germany reaching its highest level since 2012.

Since the snap election was called by Macron in June, France's benchmark 10-year government bond yield has surpassed 3.3%, marking a 12-month high.

According to David Roche, president and global strategist at Independent Strategy, a win for the left-wing alliance in the upcoming French election could have a negative impact on the economy. He advised shorting French government bonds versus German bonds, where the spread is only 70 basis points.

Shorting involves betting that the price of an asset will fall.

The president, who is discredited, negotiated a shaky alliance in a hung parliament, but there is no policy agenda, he stated.

Since the election was first announced by Macron, the most likely and least negative scenario, according to Holger Schmieding, chief economist at Berenberg Bank, is a hung parliament.

Despite being a positive outcome, it marks the end of Macron's pro-growth reforms. Any government, whether led by Gabriel Attal or a more appealing candidate to the center-left, will face challenges in achieving much progress.

A hung parliament would not be beneficial for reforms and reducing the deficit, according to Shane Oliver, the chief economist and head of investment strategy at AMP. However, he stated that it could be viewed as a least unfavorable outcome for markets because it would decrease the likelihood of a conflict over fiscal policy and prevent extremist NR policies.

—CNBC's Jenni Reid and Holly Ellyatt contributed to this article.