The eurozone economy is facing a dramatic increase in macroeconomic uncertainty. Changes in US foreign policy are forcing a re-think of Europe’s defence spending and Germany’s fiscal stance. The economic outlook is clouded by US trade policy, with the imposition of tariffs a significant shock to growth.
Our macroeconomic research team expects the direct and indirect impact of US policy to reduce the region’s growth by -0.5% to -1%. However, Europe’s fiscal policy shift should offset the drag from higher US tariffs. The ReArm Europe plan, together with Germany’s infrastructure investment fund and increased defence spending, will boost growth in the medium term, in our view.
The size of the impact will depend on the speed of deployment and the fiscal multiplier. Defence spending will likely be deployed more quickly, albeit with a lower multiplier. Infrastructure spending will likely be slower, but with a higher multiplier.
In terms of inflation, we expect further progress towards the ECB’s target, helped by the recent decline in energy prices, the rise in the trade-weighted euro, and lower services inflation. Forward-looking measures of wage pressures point to a further cooling in pay growth.
In addition, trade tariffs look set to hit growth, weaken confidence, and re-route Asian exports from the US to European markets, moderating inflation further. These effects will likely outweigh upward price pressures from any retaliatory measures from the EU.
ECB to stay the course with more cuts
In balancing the downside risks to growth and the longer-term expansionary fiscal trajectory, we believe the European Central Bank is more likely to continue its march back to neutral policy, with the depo rate reaching 2%.
We see risks around monetary policy skewed towards a more dovish outcome, that is, the ECB may be forced to cut rates to below neutral if the economy weakens and market sentiment deteriorates by more than expected in response to an escalation in trade tensions, or if trade rerouting causes a larger disinflationary impulse.
German Bunds would likely benefit from any flight to safe haven assets. As such, we have reestablished an overweight bias in euro duration.
The outlook for peripheral sovereign spreads, however, is less clear. The EU’s goal to bolster national defence spending will be constrained by ‘peripheral’ countries’ limited fiscal headroom.
Similarly, the pass-through impacts from the German growth shock should benefit other EU member states, but the associated rise in bond yields could weigh on the more indebted countries. We maintain an underweight in France versus Spain; we believe another legislative election is still likely in France and the risk of fiscal slippage remains high.
UK – Deeper and faster rate cuts ahead?
The UK economy continues to show signs of weakness, with private consumption stagnating and business investment falling. The imposition of US tariffs will be detrimental to growth. Fiscal headroom is razor thin. To keep debt sustainability concerns at bay, a thorough re-evaluation and tightening of UK fiscal policy alongside the Autumn Budget looks likely.
Businesses face higher hiring costs, which could limit hiring and push up prices. Households face a range of increases, including water and energy bills and council tax. Survey data points to further slowing in the jobs market.
The Bank of England (BoE) will likely remain focused on pay settlements as well as employment trends to judge whether the monetary policy committee can lower interest rates despite the projected rise in headline CPI over the coming quarters.
We expect faster and deeper rate cuts later this year. That said, the higher minimum wage, the pass-through from the employer tax hike, and uncertainty around trade policy look set to continue to muddy the inflation picture in the near term.
UK real yields are attractively valued, and a more dovish BoE should support Gilts in the near term. However, we are cognizant that concerns over debt sustainability, resurging inflation, and potentially inflationary Trump policies could contribute to a sell-off, providing even better entry levels. Against this background, we prefer a tactical approach when trading UK duration.
In the longer term, we believe continued slowing growth and a loosening labour market should help ease concerns over the UK’s inflation problem and allow for deeper and faster rate cuts.
We maintain a modest 2s10s nominal curve steepener. In our view, front-dated yields should be well anchored by expectations for steady BoE rate cuts. At longer maturities, the record level of net supply and concerns over debt sustainability could drive further underperformance as the term premium rises.
European investment-grade credit – Looking for opportunities
Investment-grade credit came under pressure in the risk-off move after ‘Liberation Day’. The car sector underperformed insurance, airlines and metals & mining, reflecting their exposure to any slowdown in economic growth. More defensive sectors such as utilities and food & beverage held up better.
We expect the 90-day freeze of US tariffs to reduce volatility. However, the market will likely demand a higher risk premium on credit for some time in the context of growth concerns and extremely high policy uncertainty.
Some issuers have used any moments of stability to issue bonds, while euro investment-grade remains the only pocket of credit yet to see any outflows.
We went into April with relatively low risk positioning and remain defensively positioned. We are looking for opportunities in defensive, quality names. We are overweight financials, although we have trimmed back our position.
European high-yield credit – Cyclical premium now positive
European high-yield spreads widened amid intensified growth concerns in Europe. The pricing of such concerns is usually visible in the spread between cyclical and non-cyclical risk: the high-yield cyclical premium turned positive for the first time since late 2023. However, the shift was not huge by historical standards.
The automotive premium is worth highlighting as it reached its highest level since December 2022.
Looking at the sectoral spread moves from 2-9 April, cyclical sectors such as building materials and chemicals widened by the most, while restaurants and utilities widened the least.
