Focus on fundamentals to dispel European fears, says Franklin Templeton’s Zahn
David Zahn, senior vice president and head of Franklin Templeton’s European Fixed Income team, is broadly positive about Italy but warns against political risks.
Europe has had many problems over the past five years, and some of them have been addressed. We are starting to see growth stabilise. I wouldn’t necessarily say we are seeing green shoots – that might be a bit too strong – but manufacturing is looking slightly better. For example, the eurozone economies have just exited the recession that they have been in for the past 18 months. So, what we have is slightly positive growth as opposed to negative growth, where we had been for some time.
Selection strategy within Europe is incredibly important. Up to the end of 2007, fixed income returns were relatively similar across Europe, without much differentiation between the countries. Since 2008, that has changed dramatically1. At the moment, GDP growth in Europe is fluctuating around zero, and we really haven’t seen much growth in aggregate. I believe we will see that continuing for the next couple of years. Of course, some countries are not doing so well, but others are doing very well. The yields on government debt in various countries can vary by much as 10-15% or more in any given year. That being the case, investors need to focus on bottom-up fundamentals in each individual country: which countries make sense, whether politicians are making the right decisions, where the economics are working, where they have implemented structural reforms, and so on.
From an investment perspective, it is not necessarily the case that you should invest only in the stronger growth countries. We look at relative value between countries because it could actually be the weaker growth country that would be a better investment proposition for a fixed income portfolio. We think that the best way to position a portfolio for growth or for returns is to look at the fundamentals for each individual country.
One of the markets we have been looking at a lot lately is Italy. Compared to some other countries in the eurozone, Italian bonds have had a much higher yield. The Italian government has implemented a number of reforms to boost their economy and get things moving in the right direction.
One strategic reason Zahn has for being broadly positive about Italy is its crucial role in the functioning of the monetary union. It was always likely, therefore, that eurozone policies would be oriented toward helping Italy service its debt obligations.
The biggest factor to watch in Europe is politics. People sometimes forget that the eurozone is politically driven. The problems the EU faces are not necessarily due to economics, they are more about how the politicians are acting, how are they going about making changes in their governments and policies. That’s what’s going to drive the eurozone forward in our opinion, and therefore bond market returns.
Many issues have been dealt with, but we have to remember that a lot of these imbalances have been built up over decades, and so it will take much longer for them to unwind. We believe the major volatility is probably behind us, but will there be any more bouts of volatility in the future? Of course there will be. However, we see these bouts of volatility as opportunities to reposition the portfolio. Overall, we think the path looks much steadier than it did previously.