As market uncertainty causes a slowdown in Europe’s economy, an accommodating central bank and negative interest rates are making its bond markets more attractive to institutional investors than those in the United States.

“Europe is a very export-led economy and Germany, in particular, is driven by exports to the rest of the world,” said Rod MacPhee, vice-president and portfolio manager for Franklin Templeton’s fixed income group, at an event in Toronto on Tuesday. “So uncertainty for them has a particular meaning. What they need is certainty around . . . what trading relationships are going to look like.”

He noted German manufacturers have started to pull back as a result of uncertainty from tariffs on German automobiles flowing into the U.S. and the constant delay of Brexit. “We see an economy where growth is going to be weak . . . and the inflation outlook in Europe is extremely low.”

Read: How is fixed income faring amid renewed market volatility? 

Franklin Templeton is currently overweight in European bonds and expects the continent’s interest rates are “going absolutely nowhere,” or may even drop further, said MacPhee. Looking specifically at German bonds, the yield curve for 30-year bonds is still relatively high, sloping in comparison to shorter terms and allowing investors to take advantage of the term premium.

In contrast, while growth has slowed in the U.S., it has a domestic demand-driven economy and consumers are currently doing well — the number of job openings has exceeded the number of job seekers, with wages growing as a result. “We actually see the U.S. as relatively resilient and one of the stronger economies,” said McPhee. “Although the [Federal Reserve] has embarked on interest rate cutting, we don’t see any need for the Fed to continue to cut interest rates.”

With inflation expected to rise and the Fed expected to “sit on the sidelines,” he said the firm has positioned its portfolio to be underweight U.S. bonds.

Looking at specific countries, Franklin Templeton’s main overweights are Poland and Spain in Europe, as well as Australia. Meanwhile, it’s underweight on Japan.

Australia is experiencing similar export issues to Germany, and confidence and growth are slowing, said MacPhee. In Poland, meanwhile, the economy is doing well, with higher interest rates, and its exports are primarily going to other European countries.

Read: Which emerging markets should investors be considering?

Emerging market bonds are also attractive today, specifically those with strong fiscal fundamentals, reputable central banks that can adjust interest rates and relative market confidence in those banks’ monetary policies, he said. “It’s not a case of all emerging markets are created equal.”

Meanwhile, closer to home, the spreads on Canadian bonds are crunching tighter due to high demand, said Adrienne Young, vice-president and director of credit research with Franklin Bissett Investment Management, also speaking at the event.

“We’ve got Europeans and Asians piling into North American markets, both Canada and the U.S., buying anything with a positive yield, especially the scarier stuff — the triple Bs and the double Bs — and they’re driving our spreads tighter and tighter. We face a real dilemma in the Canadian market, which is not a diversified market, which is a market that is, if you look at the universe, predominantly long-dated provincials and banks, both of which are very much affected by interest rate levels.”

In a tight-spread environment, she said, it pays to have a highly liquid portfolio and to invest in a broad range of bonds “because we’re looking essentially now for pennies under the sofa cushions. There’s not a lot of spread to be had.”

Read: Factor investing strategies becoming more popular for fixed income: survey

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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