Europe Will Likely Continue to Lead the Way in Climate-Friendly Investing

David Zahn shares his 2021 European fixed income outlook.

    David Zahn, CFA, FRM

    David Zahn, CFA, FRMHead of European Fixed Income, Senior Vice President, Portfolio Manager Franklin Templeton Fixed Income

    “The eurozone’s economic recovery may be prolonged and complicated by Brexit, but we believe policymakers’ increasing consensus around delivering monetary and fiscal support, as well as promoting a green agenda, provides grounds for cautious optimism.”

    With a second wave of coronavirus and lockdowns now under way, questions about the resilience of the eurozone economy will be prevalent in the minds of investors. Despite encouraging news of two potentially effective vaccines, it will naturally take time for them to roll out. However, in our opinion, there are positives ahead for Europe, not least the region’s unprecedented solidarity in terms of support packages, both monetary and fiscal. Furthermore, there is widespread agreement that climate change must be at the core of future eurozone policy.

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    The outlook for the eurozone is undoubtedly precarious. The bloc is beset with a new wave of COVID-19 infections, negative interest rates and deflation. Although third-quarter 2020 gross domestic product figures showed a strong recovery, the prognosis is less optimistic amid increasing predictions of a contraction in the fourth quarter. For 2021, we believe the European Central Bank (ECB) will need to maintain its accommodative stance, with a continuation of low rates and further asset purchases.

    Lagarde Continues to Pursue Climate-Friendly Agenda

    On a brighter note, we anticipate further positive developments in the European green bond market. The significant impact of climate and environmental changes across the globe has become increasingly apparent. The result in financial markets has been a corresponding increase in demand for investments that can help fund projects with positive environmental and/or climate benefits.

    In our opinion, the ECB will, in the year ahead, continue to be a leading advocate of green bonds. Since taking over the presidency of the ECB, Christine Lagarde has consistently pushed for environmental issues to be an essential part of monetary policymaking, with climate change a “mission-critical” priority for the central bank. Given her commitment to this agenda, we believe the ECB will remain a willing buyer of green bonds into next year and beyond.

    Given these tailwinds, we see further expansion of the green bond market in 2021. Germany has already issued a 10-year green sovereign bond that met with record demand. Furthermore, it intends to create a green bond yield curve by issuing green sovereign bonds in the additional maturities (i.e., two, five and 30 years) of a conventional yield curve, which we believe is an important step. The creation of a benchmark curve for the asset class would allow investors to trade these bonds more freely and help the green bond market to expand.

    Further Support from the EU

    Looking ahead to 2021, we believe the eurozone will also be supported by the actions of the European Union (EU). 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 initially proposed in May. We think the approval of this package bodes well for the European economy. The EU will begin significant issuance in 2021, a move that should reduce the risk premium 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.

    The European Commission (EC) has also made a pledge to decarbonize the economy, with a vision of zero net greenhouse gas emissions by 2050. In her State of the Union speech earlier this year, EC President Ursula von der Leyen proposed an even more ambitious target of achieving a 55% reduction in emissions by 2030 and suggested that €225 billion of green bonds should be issued to aid climate-friendly initiatives. If agreed by member states, this would consolidate Europe’s position as the leading issuer of green bonds.

    Recovery Likely to Be Slow, but Grounds Exist for Cautious Optimism

    Despite these positive developments, our optimism is cautious. The focus for the coming year will be getting the eurozone economy back on track. Many hurdles lie ahead and, therefore, we do not foresee a swift European economic recovery. It will probably take several years to return to pre-pandemic levels. Yet, for us, the building blocks are now in place from the fiscal and the monetary sides, 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. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. Investments in emerging market countries are subject to all of the risks of foreign investing generally and have additional heightened risks due to a lack of established legal, political, business and social frameworks to support securities markets.

    ENDNOTES

    1. Source: World Bank, Global Economic Prospects, June 2020. There is no assurance that any forecast, estimate or projection will be realized.

    2. Ibid.

    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity.