David Zahn, head of European fixed income at Franklin Templeton, expects markets to be extremely volatile this year, but thinks such conditions raise an opportunity for investors.  

Amidst the tariff turmoil, David Zahn (pictured) at Franklin Templeton is quite positive about the outlook for fixed income in Europe for the rest of this year. In particular, he sees opportunities in short-duration assets.

Zahn expects interest rate cuts in Europe to come this year, with two rate cuts by the European Central Bank (ECB). He thinks that the market will continue to be supportive of fixed income, especially in Europe, which offers good yields and a steady performance.

After Germany and the EU hiked defence spending earlier this year, Zahn believes that Europe is in a good place for growth, he told this publication in an interview.

The EU announced plans in March to unlock nearly €800 billion ($873 billion) to bolster security as the US suspended military aid to Ukraine and turned up pressure on the Ukrainian government to reach a peace deal. This has given rise to a big shift in the investment landscape. A number of other fund managers have become more positive about European equities as a result, such as Chelverton Asset Management, for example, and shown by this Quilter survey.

The EU's “Rearm Europe” package involves the activation of the national safeguard clause of the Stability and Growth Pact, enabling EU countries to increase their defence spending by an average of 1.5 per cent of GDP. Germany also proposed to exempt defence from a budget restriction; it will launch an off-budget infrastructure fund of €500 billion over the next 10 years. The money can be used for civil and population protection, transport, energy, education, care and science infrastructure, in addition to hospital investments, research, and digitisation. Other European nations and UK Prime Minister Keir Starmer are taking similar action.

Defence and security are underrepresented in many portfolios and have faced decades of underinvestment in Europe. Zahn pointed out that in the 1960s, defence spending was much higher in Europe and a big increase is needed over the next two decades.

He also believes that the greening of the economy will continue, with ESG-focused investments remaining a big focal point for Europe. Zahn has a number of green bonds in Europe which are continuing to do well. Although he has nothing against defence bonds, he probably won’t buy into them as a lot of his bonds are ESG-focused.

The issue over whether defence stocks have a place in portfolios, including ESG-themed ones, has become more urgent since Russia's invasion of Ukraine in February 2022. For example, Mathilde Dufour, head of research at Mirova, a subsidiary of Natixis Investment Management, concentrates on sustainable investing. Dufour also does not hold defence stocks in her portfolios as she wants clearer rules on ESG and defence investing. “We only have funds covered by Article 9 under the EU’s Sustainable Finance Disclosure Regulation (SFDR),” she said.

Asset allocation
Zahn said that market volatility this year presents opportunities for investors. "Fixed income should do well,” he told WealthBriefing. “We’ve reduced the amount we have in credit which can be expensive. Everyone is overweight in credit so it’s difficult to see how it can do better.” He is positive on European short duration assets as he believes that growth will increase, and rates could rise next year. He is also seeing investors holding fewer US assets, suggesting that European assets are a way of diversifying out of US assets.  

Zahn believes that fixed income provides a good diversifier. Within Europe, he favours Germany and Spain and is overweight in Spain. He is underweight in France and Italy, as they have fiscal issues, and has sold out of UK gilts. He has some exposure to high yield and investment grade credit, but has reduced this slightly. He also expects green bonds to continue to do quite well this year.

Franklin Templeton has four green bond funds, including the  Franklin Global Green Bond Fund, the Franklin Sustainable Euro Green Bond UCITS ETF, the Franklin Sustainable Euro Green Corp 1–5 Year UCITS ETF,  and the Franklin Sustainable Euro Green Sovereign UCITS ETF.

Franklin Sustainable Euro Green Bond UCITS ETF
Zahn manages the Franklin Sustainable Euro Green Bond UCITS ETF which aims to provide exposure to the European green bond market whilst maximising total returns. It is classified as Article 9 under the EU Sustainable Finance Disclosure Regulation (SFDR); it invests mainly in bonds that are labelled green and denominated in European currencies. The fund, which is heavily weighted towards Germany, has outperformed the index over a three to five-year period. Zahn said he invests mainly in the energy transition, namely in renewables.

He also manages the Franklin Sustainable Euro Green Corp 1-5 Year which aims to contribute to environmental goals, by providing exposure primarily to the European corporate green bond market with a short to mid duration of less than five years, whilst maximising total returns. The fund is classified as Article 9 under the SFDR, investing mainly in bonds that are labelled green and denominated in European currencies.