At the halfway point of the year, we have several significant European political events behind us, but we think politics are likely to remain a focus for investors eyeing European opportunities.
Over the next couple of months, a general election in Germany and the resumption of Brexit negotiations.
At the same time, recent political developments in Spain, Italy and Greece will likely remain on investors’ radars, but I don’t think any of these developments will radically change the overall “European project”.
Market response to the election of Emmanuel Macron as French president in May was muted, but he will need to build support in the country’s National Assembly to drive through his manifesto.
In our view, the Macron presidency will likely face some difficulties in the road ahead as French economic fundamentals continue to deteriorate.
Two major economic concerns in France — high debt-to-gross domestic product (GDP) ratio and a high current account deficit — continue to weigh on investors’ minds. Macron has said he is committed to meeting the European Union (EU) rule of maintaining France’s deficit below 3% of gross domestic product (GDP), which currently sits just above the EU target.
However, this sits uncomfortably with his ambitions to simultaneously cut public spending and boost security spending, in order to increase the number of police officers. So, we believe it will be difficult for the new government to address these issues meaningfully, and therefore we currently don’t see value in French government bonds.
German poll on the horizon
Meanwhile, anticipation is building for Germany’s general election, due to take place on September 24.
The perceived challenge to Chancellor Angela Merkel’s supremacy appears to have eased recently, but we still expect questions over immigration and labour market issues to remain centre-stage as the campaign hots up.
Fixed income outlook
We see more opportunity in sovereign bonds at the moment. We believe having flexibility should be advantageous in the current marketplace, where things are being driven so much by the political environment, as well as European Central Bank (ECB) policy.
The political uncertainty should present investors with the opportunity to chase some very different returns depending on which government bonds they own or don’t own.
Specifically, the divergence between bond yields of some Eurozone countries should bring potential opportunities for investors willing to be flexible in the way they move in and out of areas where they don’t see value.
High-yield bonds in comparison are relatively fully valued, in our opinion. The same sentiment can also be applied to investment-grade credit.
A negotiated Brexit settlement between the United Kingdom and the EU would be in the best interests of both parties, in our view, but we think UK gilts (bonds) could probably do quite well on the back of a hard Brexit — if the United Kingdom severed all economic ties to the EU.
At current levels, we consider sterling to be undervalued against the euro, and because the exchange rate is so politically driven, it would be difficult to predict how the currency fluctuates in the weeks and months ahead — we don’t see many opportunities in European currencies at the moment.
With quite a few European events coming up and the possibility of some knock-on effects, we like to think of the Eurozone sovereign bond space as a flexible option to consider.
What are the risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
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.
Zahn is the head of European fixed income and senior vice president within Franklin Templeton’s Fixed Income Group.