The Eurozone plots its long road to recovery

We at the Franklin Templeton Fixed Income Group believe Europe in general will be in a slow-growth, low-inflationary environment for a considerable time. With that backdrop, we think a long-term, accommodative approach is needed to help spur the economy.

While the European Central Bank (ECB) has a role to play in the eurozone’s economic recovery, we think the core economies should do a bit more to achieve necessary reform. We don’t think the authorities are doing nearly enough in France, for example. Their deficit is quite high, and, in the latest draft budget, the French government has effectively said it can’t meet the deficit target and will try to meet it at a later date. The country needs economic reform, in our view, and it doesn’t appear to be working hard enough on it.

Germany, we believe, is meeting its fiscal requirements very well. Still, when most other countries in Europe are in fiscal austerity, maybe Germany can afford not to be so austere.

I think some of the eurozone’s core countries could take a lesson from the so-called periphery economies. In many of the periphery countries, the authorities have enacted necessary reforms. They have put plans into place that successfully reduced their budget deficits. I’m not saying some of the periphery countries shouldn’t do more, but many reforms have been passed, and we’re starting to see them implemented.

Still in Europe, but outside the eurozone, the UK economy is moving in a positive direction, in my opinion. Growth is good, inflation appears to be under control, and the country’s central bank is in a very different place than the eurozone’s. The central bank—the Bank of England—is considering raising interest rates, and we believe it’s not a matter of if, but when it will raise rates. I think that’s a good sign for the UK economy and, as a result, we don’t believe UK Gilts offer a lot of value. For UK investors, there may be a case for looking at opportunities elsewhere in Europe because the economies appear to be moving in different directions.

Common bonds

Looking globally, I believe the eurozone has more in common with Japan than with the United States or the UK at this point, and I think that trend will likely continue. Inflation in the eurozone is running at 0.4%, which is a far cry from the ECB’s 2% target. My team and I expect inflation will likely rise a little next year, but it’s likely not going anywhere near 2%. I think that’s what ECB President Mario Draghi is primarily concerned about. He has said the ECB is fully behind undertaking whatever measures are necessary to combat low inflation.

I expect the Bank of Japan (BOJ) and the ECB should likely continue to be accommodative to combat deflation and low inflation in their respective countries. Much has been made about the amount of liquidity the US Federal Reserve Bank (Fed) has pumped into the US economy during its quantitative easing (QE) programme. But, when you take into account what Japan and Europe combined are currently contributing to their QE programmes, it probably more than matches what the United States was doing. So, on a global scale, we have probably just as much or more liquidity being created now than when the Fed was acting alone.

Divergent paths

Meanwhile, the US economy has been performing relatively well. In the United States, the Fed has indicated it is going to stop its QE programme this month, and its next focus will be on when to raise interest rates.

That’s a strong differential to make, and it has ramifications for the currencies. I think the euro should probably weaken against the US dollar and, to a lesser extent, the British pound—it has already weakened quite a bit against the pound—because the economies are on different trajectories. That might suggest to investors that European bonds may be a good place to look for potential opportunities. In our portfolio, we have taken a long-duration posture in Europe.