European Fixed Income in 2021: Focused on Recovery, and Politics

There are reasons to be optimistic the picture will look brighter for Europe by year-end.

    David Zahn, CFA, FRM

    David Zahn, CFA, FRM Head of European Fixed Income, Franklin Templeton Fixed Income

    While the calendar has turned to a new year, many of the same uncertainties of 2020 still linger—namely the COVID-19 pandemic. However, David Zahn, our Head of European Fixed Income, sees reasons to be optimistic the picture will look brighter for Europe by year-end, and is poised to take advantage of potential opportunities that arise.

    The calendar has turned to 2021, and while it looks similar to 2020 at the moment from a market perspective, there is hope on the horizon. We are still grappling with the ravages of COVID-19, but vaccinations are being administered across the globe and should help bring confidence—and economic growth—back later in the year. Europe will almost assuredly see a double-dip recession, but that is due to lockdowns that are still in place.

    As such, the outlook for the eurozone is undoubtedly precarious in the near term. The bloc is beset with a new wave of COVID-19 infections, negative interest rates and disinflation. Although third-quarter 2020 gross domestic product figures showed a strong recovery, the prognosis is less optimistic for early 2021. As such, we believe the European Central Bank (ECB) will need to maintain its accommodative stance, with a continuation of low rates and further asset purchases to support the economy and markets.

    As lockdowns are lifted, we should see an economic revival, but it could take two to three years to get back to where we were before the pandemic. Therefore, we expect to see continued ultra-accommodation from the central bank, and credit spreads will likely stay compressed. In the search for yield, we think many investors will look to central Europe and to lower credit quality.

    We believe the actions of the European Union (EU) in 2020 will support the eurozone this year. The outlook for the region was bolstered considerably in late July when EU leaders finally reached an agreement on the €750 billion COVID-19 rescue plan. We think the approval of this package bodes well for the European economy, especially in the second half of the year as the funds are dispersed. This package should also demonstrate that the rules in Europe have changed with further integration— therefore reducing the risk premium demanded on European bonds—benefiting both government and corporate issues.

    The EU will also be at the forefront of the climate-change agenda. Around 30% of the EU’s rescue plan and €1 trillion of its seven-year budget are earmarked for initiatives directed at fighting the detrimental impacts of climate change. We anticipate this will drive further investment and growth in the green bond market in Europe.

    While we expect the economy to bounce back, the markets are likely to be volatile in the coming year. We currently believe it’s prudent to keep some cash at hand to deploy when opportunities arise.

    Politics

    While the United Kingdom’s exit from the EU dominated much of 2020, this year, the focus will likely turn to political events in other countries.

    The main event to watch will be the replacement for German Chancellor Angela Merkel, who is stepping down as the de facto leader for Europe. Either Europe will not have as strong a leader for a while, or the EU will see this as its opportunity to be that strong leader, centralizing further decision making.

    Merkel’s party, the Christian Democratic Party, recently chose Armin Laschet as its new leader. He is currently prime minister of North Rhine-Westphalia, the most populous German state. He is viewed as a close ally to Merkel, so his policies would likely mark a continuation of what we have seen, and he is considered strongly pro-European. While Laschet is in a good position to become the chancellor this autumn, there are other political leaders in the mix, including the Christian Social Union’s Markus Söder. Elections in Germany will take place in September.

    The other area of political interest is the relationship between the new US administration under President Joe Biden and Europe, and what they can agree to work on together besides the obvious candidate of fighting climate change. Is this the opportunity to cooperate, or does Europe try to go in its own direction?

    We think the building blocks are now in place from the fiscal and the monetary sides for recovery, and we believe these measures should help support European bond markets for the next two or three years.

     

    What Are the Risks?

    All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.