CONTRIBUTORS
Kim Catechis
Senior Investment Strategist,
Franklin Templeton Institute
David Zahn, CFA, FRM
Head of European Fixed Income,
Portfolio Manager
United Kingdom
At its September policy meeting, the European Central Bank (ECB) lowered its benchmark interest rate 25 basis points (bps) to 3.5%, following a similar rate cut in June—which marked the first in five years. The central bank also updated its economic outlook for the eurozone, lowering its growth projection to 0.8% this year and 1.3% next year, slightly weaker than its forecast in June. It also bumped up its inflation projections slightly, to 2.9% this year and 2.2% in 2025—roughly in line with its 2% target.
If economic growth does not strengthen, the ECB is likely to continue cutting rates, weakening the euro against the US dollar and making EU exports more competitive.
The EU needs to re-energize its economy, as it is uniquely challenged by a combination of weak sovereign finances and potential trade wars with its two biggest trading partners, China and the United States (depending on the outcome of the US elections).
Despite the recent rates repricing, we still believe that if the slowdown continues, there’s a chance the ECB could turn even more dovish than the markets currently expect, confirming our bullish view on a diversified portfolio of European bonds.
Below, I offer some additional thoughts from my colleagues David Zahn and William Vaughan.
David Zahn, Head of European Fixed Income, Franklin Templeton Fixed Income
- The ECB cut interest by 25 bps to 3.5%, as anticipated by the market. We continue to see the ECB cutting rates until it gets to a neutral stance around 2%, probably at a pace of once a quarter, with the next cut likely in December.
- However, the new macro forecasts the ECB released were interesting in that they probably continue to overestimate growth over the next couple of years and will see continued revisions down in the coming forecasting cycles. The ECB rate-cutting cycle could accelerate if growth continues to disappoint.
- Overall, I think the ECB rate-cutting cycle continues to be supportive for European fixed income markets. Longer-dated bonds should become even more attractive if the market starts to believe the ECB is behind the curve.
William Vaughan, Associate Portfolio Manager at Brandywine Global
- The ECB's decision to cut rates and to trim its growth forecast by 0.1% annually through 2026, while keeping its inflation outlook largely unchanged, signals that this current position is likely to continue for some time.
- European manufacturing Purchasing Managers Indexes are clearly entering a downward trend. While the services sector has kept overall composites stable, there’s little evidence to suggest this can be sustained in the long term.
- China’s fragmented approach to stimulating demand, combined with its leadership in affordable electric vehicles, hasn't resulted in the anticipated rebound for European manufacturing.
- Italian Prime Minister Mario Draghi’s recent “EU Competitiveness” report underscores some of the eurozone’s key challenges, but spending over €700 billion annually, as suggested, seems unrealistic given the current political climate. Without significant fiscal shifts, it's hard to envision a major growth catalyst emerging in Europe anytime soon.
- Taking these factors into account, we hold a preference for European fixed income in the coming months. The US outlook remains uncertain, especially with increased fiscal borrowing and the upcoming election, making EU and UK bonds more appealing compared to the United States.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically.