Will rising French bond spreads disrupt the rally in European stocks?

French government bond spreads are surging, prompting worries about the strength of European equities amid political instability and rising borrowing costs globally. Bank of America detects risks from further yield hikes but anticipates minimal additional widening in French spreads, leading to an upgrade of French equities while retaining a bearish stance on the wider European market.

The spread between French and German 10-year yields has reached 140 basis points, the highest since the 2011-12 euro zone debt crisis, due to soaring global rates and French political uncertainty, straining financing for vulnerable borrowers. Bank strategists anticipate the spread, or OAT-Bund, to stay between 100 and 150 basis points, though a rapid shift toward the higher end would heighten the chance of policy interventions like ECB support.

European equities have stood resilient to France's fiscal concerns, with the STOXX 600 dropping about 5% from its August peak, mostly from a 50-basis-point rise in U.S. 10-year bond yields rather than fiscal risks. BofA's equity risk premium remains at a 20-year low, buoyed by robust global growth and upward revisions to earnings.

However, the bank remains bearish on European equities, forecasting a 7% decline in the STOXX 600 to 580 by Q2 2027, citing potential risks from the AI capital expenditure boom. Despite this, BofA has become less negative on European stocks, shifting from underweight to neutral. Its macro forecasts suggest limited near-term downside following Europe's recent lag.

BofA upgraded French equities to overweight, citing their underperformance and the limited room for the OAT-Bund spread to widen further. This move is partly driven by the belief that most fiscal risks are already priced in, with potential policy backstops mitigating further sovereign debt pressure. Nonetheless, the upgrade does not signify a bullish shift for European stocks, as BofA anticipates continued downside for the regional benchmark, driven by AI-related spending risks and the vulnerability of elevated valuations to higher real yields.

Additionally, BofA downgraded software stocks to marketweight from overweight, noting the sector's 30% gain since the summer.