European fixed income markets to be affected by politics in 2019

Ridhima Sharma
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European fixed income markets to be affected by politics in 2019

Politics looks likely be the main factor affecting European fixed income markets, with the eurozone’s economy and the ECB’s monetary policy both set to continue on much the same paths as before.

Domestic political events are likely to be the main influence on European fixed income markets in 2019, in our view. The degree of uncertainty is considerable, with German and Italian politics as well as the scheduled culmination of Brexit negotiations all potential risk factors. Any resulting market volatility from these or other political issues could provide interesting opportunities for active investors. However, the backdrop for the eurozone economy over the next 12 months looks fairly stable, with the region’s growth rate set to remain relatively healthy. Though the European Central Bank’s (ECB’s) quantitative easing is due to end at the start of 2019, we believe policymakers will remain firmly tilted toward an accommodative stance, attempting to ensure inflation continues and slowly moves up toward the ECB’s target.

A weaker chancellor Merkel, Brexit and Italy could increase market volatility
It seems the only safe prediction for Europe’s politics in 2019 is that uncertainty will continue and could well intensify. The declining authority of German Chancellor Angela Merkel creates the potential for more instability. For so long Merkel has been the undisputed leader of her country and the most powerful figure in the European Union (EU), but having stepped down as head of the Christian Democratic Union (CDU) party, she is by no means guaranteed to see out her term as chancellor, which runs until 2021. Germany’s ruling coalition looks increasingly fragile, as all of the parties within it have repeatedly performed badly in elections. Merkel’s departure as CDU party head adds to doubts as to whether the government can survive in its current form.

Chancellor Merkel’s troubles also mean the EU must navigate difficult waters with its main powerbroker much diminished. The United Kingdom (UK) is due to leave the EU at the end of March, and though agreement has been reached between the two sides on the terms of the UK’s departure, UK Prime Minister Theresa May faces a difficult task in winning domestic support for a deal. The possibility of a chaotic “no deal” scenario or of fresh UK elections persists, but we think the most likely outcome is one that keeps the UK fairly closely tied to the EU.

As soon as the current populist Italian government was formed in June 2018, a fractious relationship with the EU appeared likely, and so it has proved to be thus far. Proposals to increase Italy’s public spending far beyond the levels permitted by the EU’s fiscal rules have fueled concerns among investors about the sustainability of the country’s public finances, pushing Italian government bond yields to multi-year highs. With the populist coalition maintaining its defiant stance, a further spike in yields cannot be ruled out. And if fresh elections were called, the result could be increased support among the country’s voters for euroskeptic policies.

The potential for market volatility affecting Italy and beyond remains high, but we still believe that a compromise allowing a limited expansion of the country’s public spending is likely, avoiding an escalation of the crisis. A deal could also serve as encouragement for other eurozone countries to modestly loosen their fiscal stance. Any such measured easing of austerity might help incumbent European governments to check the decline in support for traditional parties and help to win back voters, who have increasingly turned to populist agendas.

Broadly stable economic and monetary backdrop as Draghi’s term comes to an end
In comparison to politics, the European economic outlook for 2019 does not appear to offer the same potential for surprises, at least not in terms of what can be reasonably anticipated. The ongoing strength of domestic demand in the eurozone should more than offset a recent weakening of sentiment among exporters due to global trade concerns. A combination of above-trend but not exceptionally strong growth along with weak but slowly rising inflation is likely to continue. Consequently, the ECB will probably hold back from raising interest rates despite ceasing its bond purchases at the start of 2019. But with Mario Draghi due to step down as ECB president in October 2019, much attention will be paid to the appointment of his successor—as well as those filling other senior positions up for renewal at the central bank—and the potential implications for the future tone of ECB policy.

External factors may also influence investors as they assess allocations to European fixed income markets in 2019. The persistent rise in US interest rates during 2018 has made the cost of hedging US dollar-denominated assets much more expensive for European investors, lowering the attraction of higher-yielding US bonds, and increasing the relative appeal of investing closer to home. More widely, for the first time since the global financial crisis, the cumulative effect of the major central banks’ operations is likely to withdraw liquidity from financial markets, following many years when investors could rely on central bank policy to provide excess liquidity. The impact of this potential turning point in global monetary policy is perhaps the most significant unknown for investors in 2019.

David Zahn, head of European Fixed Income, Franklin Templeton Investments

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