European debt markets face a number of challenges this year against a backdrop of weak economic growth and political volatility, according to David Zahn of Franklin Templeton Investments.
The head of European fixed income says European debt markets have been underpinned more recently by a period of weaker GDP growth.
The recovery we had in 2004 and 2009 is much stronger than we had more recently,” said Zahn (pictured), adding that the recent recovery started in 2013 had been “very weak, very slow”
Yet, Zahn says there is scope for more fiscal weakening in European countries given the compliance with Maastricht deficit guidelines.
Weaker growth has come at the same time as a resurgence of populist political parties during what will be a key year for some of Europe’s key members.
Volatility is expected to increase around the first round of French presidential elections, says Zahn, where right-wing politician Marine Le Pen of the Front National is expected to poll better. Indeed, Zahn says he has zero in French sovereign bonds ahead of the elections.
However, in Germany Zahn expects very little to change as Angela Merkel is widely expected to be returned as chancellor once more.
Another key issue facing European leaders in 2017 is the activation of Article 50 of the Lisbon Treaty by the UK, triggering the start of the exit talks from the EU.
Zahn says a deal is likely to be reached in the interests of both the UK and EU, noting the potential impact on countries who rely on Britain for exports of goods and services.
While British politicians have been vocal in their desire for a ‘hard’ Brexit – cutting off all special ties with the trading bloc – European politicians have been subtler, says Zahn.
Zahn says the British government holds a number of strong bargaining positions ahead of negotiations, such as access to the City of London and its institutions.
As few details have yet to emerge about what kind of deal the UK government will seek – although prime minister Theresa May is speaking on the issue today – some political commentators have suggested that a deal similar to Norway could eventually be reached, in which the UK pays into the EU budget in exchange for access to the single market.
“This deal will be done between all nations not just Brussels,” he said. “I think it will be more definitive than a Norway model: it will be a UK model.”
Zahn says while the UK is likely to continue paying into the budget, it will no longer be the second largest contributor as under the current system.
The portfolio manager says he has increased exposure to UK debt more recently as fundamentals have strengthened following the decision to exit the EU.
“I still think that sterling bonds do look good in a European portfolio and we are overweight UK gilts,” he said.
While anti-Brexit campaigners had warned of a slowdown in economic growth in the event of a vote to leave the EU, the UK economy has proved resilient in recent months.
“In terms of economic growth, nothing has changed,” said Zahn, adding that GDP growth is unlikely to change until details of the deal sought emerge.
As industry commentators have predicted a surge in inflation during 2017, Zahn says that in the UK rates are likely to pick up in the near-term before later tailing off as in Europe.
In the European debt market, Zahn continues to favour Italian government bonds but yields are higher but does not own lower yielding German or French sovereign bonds.
Despite the issues facing the Italian economy, particularly ahead of elections anticipated later this year following the referendum on constitutional reform late last year, he continues to hold Italian government bonds.
“I think the government will continue with some of the reforms, some are still working their way through the system,” he added.
In France, Zahn highlights the country’s large budget deficit with debt-to-GDP continuing to rise, with uncertainty posed by the upcoming presidential elections.
Outside of Europe, the election of Donald Trump as US president is likely to put pressure on his NATO allies to increase spending on defence, says Zahn, with Spain needed to increase spending by four times and Germany by twice as much to reach the 2 per cent of GDP required under the NATO Treaty.