France's election has the ability to rock wider European stocks, Citi strategist says
France's parliamentary election has already rattled investors as the country's risk premium rises — but two possible scenarios have still not been priced in by markets and could impact stocks in the wider European region, according to Citi.
"Our model suggests that the market is pricing in something between a benign outcome and a gridlock ... not completely, but we are a few percentage points away probably from fully pricing the gridlock," Beata Manthey, the bank's head of global equity strategy, told CNBC's "Squawk Box Europe" on Friday.
"However, the market is not priced in for far-right or far-left majority," Manthey said.
The tax and spend plans of both the hard-right Rassemblement National (RN, or National Rally) party and the left-wing Nouveau Front Populaire (NFP, or New Popular Front) coalition are a key cause of concern over future bond market volatility. Some economists have warned that if either were to form a majority and quickly push through the majority of their proposals, it could tip over into a debt crisis.
Both parties are seen outperforming the centrist coalition containing President Emmanuel Macron's Renaissance party in Sunday's first round vote. However, the path from there looks deeply uncertain.
A benign outcome from a market perspective could involve the centrists finding some path to victory, or a hung parliament in which no party is able to progress with their agenda.
Citi performed a scenario analysis of different outcomes and what they could mean for Paris's CAC 40 stock market index — also based on potential movements in the spread between French and German bond yields, which hit a 12-year high Friday.
"The outcome is still quite unclear, we only have polling for the first round of the election. So we'll know much more on Sunday evening," Manthey said.
"Let's put the announcement of the election in the context of the positioning of the investors. Europe has been a very popular market, has been outperforming, international investors have been shifting away from the U.S. to Europe, positioning has been stretched or net long, extended long, especially on the European banks. And that has all unwound now to neutral, but it's not negative," she said.
European stocks are trading close to a 40% discount to the U.S., a "huge" gap compared to a historical average of around 15-20%, she said.
"But valuations need a trigger. The increased political risks are not a trigger, that's what I worry about ... our model suggests right now, it's fairly priced for what the analysts expect on the fundamentals front," she continued.
"Let's put it this way, we've downgraded Europe, upgraded the U.S., on the back of increased political risks. European, within developed markets, equities tend to be the most vulnerable to these changes."
If the French election outcome "is very market unfriendly ... markets in Europe are quite correlated. So if [the] CAC sells off substantially, you have spillover effects elsewhere as well," Manthey added.