Moody’s Muddled French Markets

Monday, credit ratings agency Moody’s downgraded France one notch from AAA to Aa1, following a similar decision by Standard & Poor’s in January—and sparking much speculation about the state of the French economy. Along with the downgrade, Moody’s maintained its negative outlook, citing competitiveness issues and French bank exposure to weaker eurozone countries. The implied threat being Moody’s may downgrade France again if the country doesn’t take further efforts to relax labor laws and/or fails to cut public spending. Partly explaining why some seem to believe the downgrade reflects lack of confidence in French Prime Minister FranÇois Hollande and legislation he passed earlier this year, like a 75% tax on income over €1 million, higher minimum wages and lower retirement ages for some.

But should these factors truly underpin Moody’s downgrade, their timing seems a bit ... off. Of late, Hollande has seemingly veered in a more pro-business direction. Recently, he offered €20 billion in “annual tax relief to companies, equivalent to a 6 percent cut in labour costs, to spur competitiveness.” He also proposed cutting the budget by €30 billion to rein in the deficit and declared his intent to reform rigid French labor laws. Whether such changes continue remains to be seen, but previous and proposed action to loosen up the labor market seem headed in the right direction.

Also odd is Moody’s timing from an interest rates perspective. Now, one common critique of raters is they tend to follow markets. That doesn’t appear to be the case here—kudos, Moody’s! But, again, their timing still appears ... strange. Following S&P’s January downgrade, rates slid all the way to record lows reached just weeks ago. At the November 15 auction, France sold €8.8 billion worth of bonds, with two-, five- and 10-year bonds at record low yields. We believe the strength of this sale likely reflects depth, liquidity and confidence in the French bond market. Though issuance of French debt is now finished for 2012, the results show, like German bonds, French bonds are still seen as safe investments. And demand reflects this reality: At 55%, foreign investors still the hold the majority of French bonds—showing they don’t seem especially worried about the potential for downgrades, though credit ratings agencies have been all over eurozone nations for years now.

And that, folks, is the opinion that matters most to us—the market’s. Reviewing rates’ deep dive since S&P’s downgrade—and Hollande’s election—it would seem investors are plenty confident in the French economy. Likewise, French economic growth, though not gangbusters, has shown resilience in the face of the eurozone’s travails. French GDP rose 0.2% in Q3 2012, beating expectations. So the reality of French GDP and bond yields seems a bit detached from the direction of Moody’s ratings.

Like the 2011 US downgrade over debt ceiling fears, popular hyperbole and fear seem to have driven France’s recent downgrade more than its economic data or market performance. In fact, downgrades often don’t reflect economic reality now or moving forward—just like a negative outlook isn’t a guarantee another downgrade is coming. The bottom line is that yes, the market’s opinion is not infallible, but it’s far more accurate than most—especially the credit raters, whose history is rife with misses and short on hits.