As almost all Eurozone countries have reduced their budget deficits below the 3% threshold, many governments are now in the position to increase fiscal spending. With more than 40% of the eurozone’s population going to the polls in 2017, amid a surge in popularity of populist movements, there’s more than a small chance this will happen.
If fiscal policy partly replaces QE, as Mario Draghi has repeatedly been calling for, this would not be supportive for bonds, admits Zahn. “It would make us reduce our duration to about 3.5. But I believe the likelihood we will see large-scale fiscal stimulus is low.”
However, even if Zahn is right, the potential returns from government bonds are so low that investors are probably right to underweight the asset class.
Returns from government bonds are going to have to come from asset allocation decisions, as return dispersion within the asset class that characterised 2016 is likely to persist.
Zahn dislikes French government bonds, citing the relatively low 10-year yield (0.75%) compared to its weak fundamentals: France has the second-highest budget deficit in the eurozone, a fast-rising debt/GDP ratio and low growth.
Though Italy’s fundamentals are arguably even a lot weaker than France’s, Zahn has a strong preference for Italian bonds. The Italian 10-year yield has almost doubled to 1.85% since August.
Government bond managers are indeed taking diametrically opposed positions at the moment, so as bond returns have started to disperse it is starting to matter more which manager you pick.
Kommer van Trigt, manager of the Robeco Global Total Return Bond Fund, is anticipating further underperformance of Italian government bonds. “New turmoil lies ahead in Italy, with either a referendum to repeal the labour market reform or early elections, while fundamentals remain weak,” he says.