Europe's Economic Struggles: A Silver Lining for Fixed Income Investors

The eurozone has been grappling with significant economic challenges, with GDP growth consistently and meaningfully lagging behind the United States, due to subpar performances in Germany and France. As Europe faces its hurdles, such as elevated energy prices and competition from China, we believe there are both opportunities and risks in the region.

The eurozone's economic struggles are rooted in a mix of cyclical and structural factors. Relative to the U.S., Europe’s fiscal push was less aggressive, which contributed to its underperformance. Structural issues, such as lagging technology and productivity, alongside very weak investments, have further hindered growth.

While there are signs of green shoots in the economy, such as a slight uptick in recent Purchasing Managers' Index (PMI) data, this optimism is tempered by potential seasonality biases and stockpiling by U.S. companies ahead of tariff implementations. Moreover, political uncertainty, particularly in Germany and France, is leading banks to tighten credit conditions, posing a headwind to growth. According to the European Central Bank’s (ECB) January 2025 bank lending survey, euro area banks reported a renewed net tightening of credit standards for loans to enterprises, driven by higher perceived risks related to the economic outlook and banks’ lower risk tolerance.

Trade troubles

The European outlook would be challenging even in the absence of a more adverse and uncertain global trade environment, which represents a significant additional headwind for Europe’s export-dependent economy. The outlook for U.S. trade policy under the Trump administration remains unclear. Initially, Canada, Mexico and China were the main focus of trade measures, but recent rhetoric and actions point to a broadening of trade restrictions, with Europe coming into clear focus.

While it remains to be seen how aggressive tariff policy will end up being, the mere threat of trade disruptions is likely to increase corporate caution. This was seen in 2018-19 under the first Trump administration, when companies curtailed investment plans due to heightened uncertainty. In this environment, subpar growth is our base case for the euro area. However, a full-blown trade war could easily push the region into recession given its already weak growth base.

For Europe, the potential for a broader slowdown in global growth exacerbates these challenges, driven not only by U.S. policy decisions but also China’s economic performance. While some market participants are counting on a more expansionary fiscal stance in Germany following the upcoming election later this month, we believe any changes will be incremental rather than representing a fiscal sea change. Similarly, while we think a resolution of the Russia-Ukraine war could be a positive for European growth, we would not overplay the impact on the economy.

Amidst these challenges, inflation dynamics offer a glimmer of hope. Inflation across developed markets has been moving towards central bank targets, driven by normalising labour markets and a cooling global economy. This trend should allow central banks, including the ECB, to continue cutting rates in 2025. PIMCO anticipates that the ECB will cut rates more aggressively than the market currently expects, which is a terminal rate of around 2%. This outlook is supported by the weak economic environment and progress on disinflation (even though a “last mile” disinflation hurdle still needs to be cleared). In contrast, the U.S. Federal Reserve is expected to be more cautious in its rate cuts due to the resilience of the U.S. economy and the potential inflationary impact of tariffs.

Investment Implications

In this uncertain environment, we see a favourable landscape for bonds. With current yield levels significantly higher than those before the pandemic, there are attractive opportunities for fixed income investors. We view European duration as attractive, particularly in the 5- to 10-year part of the curve, while we tend to be underweight the long end of the curve due to increased sovereign issuance and reduced central bank support. Having duration exposure in portfolios also offers significant upside in the event of more adverse global trade scenarios.

Outside of core duration, sovereign spreads to German bunds in the region are relatively tight from a historical perspective. However, we see more stability in this space compared to a decade ago, as the ECB has asserted its role as a lender of last resort for sovereigns, amidst improving fiscal cooperation and a general decline in Euroscepticism.

On equities and risk assets more broadly, there is reason to remain cautious given the challenging macroeconomic outlook and what we view as complacent valuations. In the currency space, we prefer to be underweight the euro against the dollar, given the macroeconomic outlook and ongoing tariff risks.

Summary

The European economy, particularly Germany, is struggling with stagnant GDP and structural issues such as lagging technology, high energy prices, and intense competition from China. Political uncertainty further exacerbates the situation, leading to tighter bank credit standards. Last but not least, increased global trade uncertainty poses a significant headwind for Europe.

There are also positives for the region compared to a decade ago: the ECB's ability to act as a lender of last resort, improved fiscal cooperation, and reduced Euroscepticism. Overall, the outlook presents significant opportunities for fixed income investors.