Voters turn right, investors to Germany

Fears that Europe is headed for a period of intense political and social instability amid a worsening economic backdrop sparked heavy falls in global sharemarkets overnight.

The falls were concentrated in the main European bourses. In Paris, the CAC 40 lost 3.1 per cent, falling to its lowest level in 2012. Meanwhile, the Italian stock market closed 3.8 per cent lower, while German shares fell 3.4 per cent.

Investors are worried that Europe is facing a full-scale political and social backlash against fiscal austerity at a time when the region is sliding deeper into recession. Mainstream political parties are struggling to convince voters that they will deliver jobs and economic prosperity and preserve Europe's generous welfare state from savage budget cuts.

Faced with rising unemployment and a bleak economic outlook, voters are increasingly turning to fringe political groups, such as the anti-immigrant National Front of Marine Le Pen, which attracted 17.9 per cent of the vote in the first round of the French presidential election on Sunday.

In the wake of Sunday's results, French president Nicolas Sarkozy declared that the National Front's strong showing was "a vote of suffering”, and likened it to "the expression of a revolt". For his part, the French Socialist candidate, Franois Hollande, who won the first round of France's presidential elections, declared that it was important to listen to "these men and women who no longer know to whom they should turn”.

At the same time, investors also fear that Hollande's first-round victory will mean renewed wrangling over Europe's economic strategy. Hollande has already signalled that he wants to change the German-led fiscal pact so that it puts more emphasis on economic growth, rather than austerity. And Hollande is likely to enjoy the backing of Italian leader Mario Monti and Spain's Mariano Rajoy.

Fears over growing political instability in Europe were also fuelled by the collapse of the Dutch government. Prime Minister Mark Rutte and his cabinet tendered their resignations after the far-right politician Geert Wilders pulled out of negotiations on cutting the budget deficit. Analysts said that the collapse of the Dutch government, which had been a steadfast supporter of the German-led austerity approach, showed that the eurozone's current strategy, which emphasises budgetary discipline rather than economic growth, was no longer politically viable.

But advocates of the austerity approach were quick to lash back. In a speech in New York, head of the powerful Bundesbank, Jens Weidmann, pleaded for eurozone leaders to persist with tough budget-cutting measures. "We can only win back confidence if we bring down excessive deficits and boost competitiveness,” he said. "In such a situation, consolidation might inspire confidence and actually help the economy to grow.”

Meanwhile, the gloom over the eurozone's economic outlook worsened after the purchasing managers' indices for the region showed private sector economic activity contracted sharply in April, falling to its lowest level in five months. The figures were all the more worrying because economic weakness appears to be spreading to the German manufacturing sector and the French services sector.

Heightened political and economic tensions are also becoming apparent in European bond markets. Fears that countries such as Spain and Italy will ultimately abandon attempts to impose budgetary discipline pushed their yields higher, with Spanish 10-year bond yields climbing to 5.94 per cent, while Italian yields rose to 5.7 per cent.

At the same time, investors flocked to the perceived safety of German bunds. Yields on 10-year bunds fell to a euro-era low of 1.63 per cent, which is well below the eurozone's inflation rate of 2.7 per cent.