Weaker Growth Means Lower Rates
While anything is possible at this stage, there could be opportunities to avert the worst-case outcomes. Tariff proposals may not be fully enacted, as targeted countries may mitigate impacts through bilateral negotiations and concessions on non-trade issues. Also, companies have learned to better manage tariff risk (from the first Trump presidency) and supply chain resiliency (during COVID). Lastly, Trump has vowed to end the conflict in Ukraine, potentially reducing spending needs there.
Even so, European economies are already struggling to return to meaningful growth after the pandemic, and an external shock could push the region into recession. The market expects the European Central Bank’s (ECB’s) policy rate to settle at 2.0% to 2.25% over the next few years.
We think that level is too high and rates will fall further, as Europe faces the same structural problems as before the pandemic. Fresh challenges from Trump’s policies could mean even more ECB and Bank of England rate cuts. Meanwhile, Trump’s policies could result in higher US nominal growth and inflation, and fewer cuts from the US Federal Reserve.
Bond Markets Could Enjoy a Powerful Tailwind
The prospects of much lower rates in Europe and stronger growth in the US will likely be major positives for euro and sterling bond markets over the next two years. We expect lower yields at the front end of the curve, with marginally higher yields only at the very long end (30 years) due to fiscal deterioration.
Investment-grade issuers with the strongest financials will be the most resilient to tariff pressures, and their bonds should benefit most from falling rates, in our view. High-yield issuers are more sensitive to changes in economic prospects and could be more impacted by a growth slowdown. Even so, European high-yield markets start from a position of strength, with mostly robust fundamentals and strong demand relative to supply. In particular, around 65% of the high-yield market is rated BB, and issuers in this group don’t necessarily need strong growth to service their debt. But we think the lower-quality, more indebted issuers rated CCC and below will likely need growth to sustain their capital structures and are vulnerable to a slowdown.
As rates continue to fall, we think European investors that shun bonds and stay in cash could incur a sizeable opportunity cost.
Active Management Can Play an Important Role
Although the overall impact of the new US policies on European economies and businesses may be negative, we anticipate wide dispersion of outcomes across issuers, sectors and countries. Many issuers of euro-denominated debt, for instance, are multinationals less geared to the European growth cycle. Euro-denominated debt issued by US companies can benefit from both falling euro rates and stronger US economic growth. And issuers’ exposures will likely change over time as policies evolve. Thus, skilled active managers may find opportunities—particularly those that run dynamic risk-aware strategies.
The European Project May Reach a Crossroads
Trump rejects human-caused climate change theories and favors abundant energy supplies, including hydrocarbons, to fuel US economic growth. He’s tasked his team with significant deregulation and government cost-cutting and intends to extend tax cuts due to expire in 2025. In the short term, we think his policies could sharpen US companies’ competitive edge and widen the gap between US and European economic growth rates.
As European governments are already facing a voter backlash over high energy prices, pressure will likely build for the European Union (EU) and UK to reevaluate the pace of their green transitions. Policy changes in the US could also escalate calls in the EU for a more ambitious euro-area program to improve competitiveness and cohesion, including further EU borrowing powers.
Investors will need to stay alert to these events as they unfold and to moves in securities prices that could over- or under-discount the actual impacts of change. Tools that can objectively analyze and consistently evaluate financially material ESG metrics and systematically harness quantitative and fundamental research across vast numbers of bond issues will be vital. It’s only by developing these capabilities that investors can fully assess the impact of potentially wide-ranging changes, and so mitigate risks and capture opportunities during Trump’s term and beyond.
