UniCredit Coffee Break

Tonight, Moody's will review France’s credit rating, which is currently at Aa3 with negative outlook. We expect the rating agency to downgrade French public debt as deteriorating fiscal indicators are compounded by political constraints that hinder efforts to place public finances on a more sustainable path. With S&P and Fitch already placing the country’s rating credit one notch lower, we think this move is broadly expected and should not lead to a further underperformance of French govies. The 10Y OAT-Bund spread is currently trading at around 175bp, 90bp wider than at the beginning of September and at the highest level since its peak in November 2011.

That said, a rating downgrade would keep investor attention high on the political uncertainty and weakening economic fundamentals in France. Next year’s presidential election represents a source of concern not only for France but for the entire eurozone, and adds to other risk factors such as geopolitical tensions and elevated energy prices. The mix of internal and external risk factors is blurring the economic outlook for European companies. However, they have so far proved resilient.

Today, PMIs will tell us whether this solidity is still in place in October. We expect PMIs to remain high, close to September levels, indicating that companies continuing to navigate current challenges relatively well. Indeed, we think that the risk of an economic downturn is limited thanks to both public and private investments. This is broadly reflected in market valuations given the overall resilience of equity prices, although they have experienced more volatility in the past few weeks.

As depicted in our chart, eurozone real rates remain elevated, despite a recent moderate decline, with the 5Y real rate trading in the 1% area. This recent move probably reflects a flight to quality, with investors turning to Bunds and swaps, reducing positions on peripherals, and potentially due to a re-equilibration in rate components following the increase in market-based inflation expectations. Our chart also shows the recent correction in gold prices. Gold is expressed in EUR terms, which limits its recent decline in light of the USD's strengthening.

For reference, gold has lost 7% in USD terms and 4% in EUR terms. As we commented in our Quarterly Updates - Overlapping shocks, this correction reflects the increase in yields (especially the real component) since the beginning of September, while resilient ETF inflows, central-bank demand and diversification needs have provided a floor to gold prices. Since going long gold is usually associated with fiscal risks or the possibility of an economic downturn, its recent price fluctuations imply that recession risks are perceived as limited.

While equity markets have recently seemed able to mostly absorb the latest risks, the long­term direction of asset valuations remains to be seen. Next week’s central bank meetings will shed light on how officials interpret the latest fluctuations in energy prices, recent macroeconomic data and political uncertainty stemming from the midterm elections in the US, as well as the situation in France. Even more importantly, investors will try to understand whether higher refinancing costs and wider spreads are perceived as a major threat to economic growth in both the eurozone and the US.