Coming Out of COVID-19: A Look at Interest Rates and Inflation in Europe

February 28, 2021

6 minute read

by David Zahn, CFA, FRM, Franklin Templeton Investments

There is hope that economies will see a more sustainable and robust recovery this year, given unprecedented levels of monetary and fiscal stimulus and as more individuals are vaccinated against COVID-19. But one question for investors is what happens next—will inflation and higher interest rates be a consequence? Our Head of European Fixed Income David Zahn shares his views.

The challenges of COVID-19 and a prolonged low-interest-rate environment have caused many investors to question their fixed income allocations. From a European perspective, we still see plenty of potential opportunities in the year ahead and beyond.

The Inflation Factor

Inflation is certainly on the minds of many investors, given what looks to be a stronger year of growth in many economies amid a continued recovery from the pandemic. We have seen US Treasury yields rise amid the threat of reflation, and bond yields in Europe have followed suit.

Our view is that interest rates are not going up in Europe to any meaningful degree this year. While it seems likely we will see a move higher in inflation in the United States, a lot of it could be transitory and confined to certain sectors. Whereas in Europe, in our view, the chances of having durable inflation remain incredibly low.

The rate of consumer price inflation for the euro area was 0.9% year-on-year in January 2021, rebounding after several months of negative readings. The European Central Bank (ECB) has forecast eurozone inflation to rise to 1.3% by 2023, but it has been overshooting for years. While inflation could move a bit higher from current levels, it doesn’t mean it will be something severe enough to spook the bond market or cause the ECB to change its policy course.

The reality is the recovery from COVID-19 will take several years in Europe to get back to pre-pandemic levels. In this type of environment, we think the ECB is going to remain very accommodative and is likely to continue its asset purchasing programme, which has flooded the market with liquidity. Given the likelihood of a slow recovery, we don’t see interest rates rising in the euro area for at least five years. Remember, it took Europe over a decade to get back to where it was before the global financial crisis of 2008-2009.

We do think the authorities in Europe are learning the lessons of the past and are now more willing to spend when they should—when the economy is weak.

Politics in Europe

Of course, politics in the eurozone is always something for investors to watch. With German Chancellor Angela Merkel stepping down this year, there is a power vacuum at the top and it will be interesting to see who fills it. Former ECB Chair Mario Draghi has stepped back into the political fray, becoming prime minister of Italy on 13 February. I think this is a positive step forward for Europe as a whole as he is one of the most respected politicians within Europe and is pushing for a lot of reform at the European level, in addition to reform in Italy. We think this new political dynamic will be quite interesting to follow and could have real ramifications on how the EU and European governments function, which could impact markets. We believe there will be more centralisation of control, which is really important because it means that Europe will become much more investible for the global audience, particularly given the large EU issuance of pan-European debt tied to the pandemic response.

Importance of an Active Approach

The COVID-19 crisis has refocused many investors. One area garnering more attention is environmental, social and governance (ESG) issues. Investors are asking: what can I do to make my investments be more sustainable? What can I do with my investment dollars to actually help mitigate climate change? We believe these issues will become even more important in the next couple of years and will drive more investment flows. That doesn’t necessarily mean investing only in companies with the highest ESG scores.

We actively seek companies that have work to do in this area but are open to positive change. Maybe they have a bad carbon footprint or detrimental social issues, but management recognises this and sees a need for improvement in these areas. These kinds of companies can add a lot of alpha and value as they improve. It doesn’t happen overnight, but over several years and with continued engagement, we can see big strides in this area. There are a lot of corporate issuers which are at a very early stage in terms of addressing ESG—if they are willing to communicate and engage, we see that as very promising.

That all leads to our belief in the importance of an active approach. In our view, over the next 12 to 18 months, bond markets are likely to be volatile. As such, we believe strongly in the value of active management; investors need to be nimble and may need to make portfolio changes to generate alpha. We also believe it’s important to have a bucket of liquidity to deploy when potential opportunities arise.

Even though there are potential headwinds and uncertainties, we still see new opportunities within European fixed income. We think select double B rated high-yield bonds look quite attractive within Europe, for example, as part of a barbell strategy with some lower-risk and some higher-risk investments within a portfolio. And we’re not just looking at the eurozone for opportunities; we are looking at all of Europe, including countries in emerging Europe. In our view, fixed income still functions as a diversifier during times of stress in the marketplace, and we aren’t completely out of the woods yet in regard to the fallout from the pandemic.