Franklin Templeton's Zahn sticks with German and Spanish debt as European growth slows

The positioning points to a preference for higher-quality euro-area debt over countries where political risk is greater. French and Italian bonds are opportunities for later, not for immediate buying. As the Budget approaches, gilts come with the clearest event risk, and the worry is that investors would react badly to a smaller fiscal cushion, even though no sharp sell-off is expected. Too many rate increases are already priced in, in this view, leaving some room for yields to edge down over time, though not fast. This is one investor's view rather than a market consensus, so gilt and euro-area spread moves will depend on Budget details and upcoming growth figures.

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The head of European fixed income is tilting toward German and Spanish debt, avoiding French and Italian political risk, and monitoring the UK Budget for any reduction in fiscal headroom.

Summary:

• Franklin Templeton's European fixed income head, David Zahn, says the European economy has performed better than expected but is likely to weaken from early next year as higher gas prices and interest rates take their toll.
• He believes investors have priced in more rate increases in Europe and the UK than are likely to happen, and the European Central Bank may eventually want to reverse some of its earlier moves.
• He is overweight in Germany and Spain, which he regards as the most stable markets in the region, and underweight in France and Italy because of political turbulence and Italy's election next year.
• He has a modest 10-year gilt position but is cautious about UK fiscal and political uncertainty.
• His central concern for the UK Autumn Budget on October 28 is a loss of fiscal headroom, and more tax rises would not surprise him.
• He sees bond yields of around 5% in the UK and around 4% in Europe as attractive and keeps a positive view on green bonds.

Franklin Templeton's European fixed income head, David Zahn, says European growth has proved more resilient than expected but is set to lose momentum early next year, with expensive gas and higher rates expected to weigh on activity. A significant slowdown is on the way, he said, and the European Central Bank may eventually want to undo part of its earlier rate rises.

In Zahn's view, markets across Europe and the UK have priced in too many rate hikes, and the recent increase in yields should itself act as a drag on growth. He does not expect yields to come down quickly, however.

His positions clearly favour stability. Zahn is overweight Germany and Spain, the two markets he considers most stable in the region, and also holds Poland and Romania. Germany, he says, is the world's triple-A asset, with an improving growth profile even as the government spends heavily. France and Italy are underweight, reflecting political turbulence in France and the Italian election next year. For France, he does not anticipate meaningful narrowing of spreads before April or May at the earliest, depending on polling, and regards it as a possible opportunity rather than an immediate one. For Italy, he expects the government to ease its budget and increase spending before the vote, while the still-high debt stock is a worry for longer-dated bonds.

Despite those concerns, Zahn says bonds now provide a reasonable income, with yields around 5% in the UK and around 4% in Europe. That makes them more appealing relative to equities than before, in his view, because a bond held to maturity repays what was paid for it. He remains positive on green bonds, which he says have become cheaper.

In the UK, Zahn maintains a small position in 10-year gilts, which he says have beaten French and Italian bonds, but his exposure is limited by fiscal and political uncertainty. The Autumn Budget on October 28 is building into a bigger event, he says, with the key risk being a cut to fiscal headroom at a time when markets are volatile. Further tax increases would not come as a surprise, and he does not expect the gilt market to respond well, although a large sell-off is not something he predicts.