European fixed income: 2025 outlook

Investors are entering 2025 amid uncertainty, driven by political changes in both Europe and the United States. The European economy is expected to experience sub-trend growth with supportive monetary policy, which should benefit European bond markets in the medium term. However, the potential for elevated volatility underscores the importance of active investment management.

The election of Donald Trump as US president, coupled with Republican control of Congress, introduces uncertainty for European economic growth. The US remains a crucial export market for Europe, and Trump's proposed tariffs could negatively impact this relationship. Although the direct GDP impact is expected to be modest, the broader trade tensions may deter investment and consumption due to increased uncertainty.

European governments might need to increase defense spending in response to Trump's stance on military aid, though this spending typically has a lower economic multiplier effect. These developments could weigh on European growth, although a strong US economy could offer some positive spillovers.

The European Central Bank (ECB) is likely to adopt more accommodative policies, potentially cutting interest rates further than expected. This suggests that shorter maturity European bonds may outperform longer maturities, which are more influenced by US Treasury yields. The ECB will also need to monitor the euro's exchange rate to manage inflation risks.

In this environment, European bond investors could benefit from declining yields and supportive monetary policy. However, political and economic divergences across European countries necessitate careful portfolio construction. An active approach to security selection will be crucial in capitalizing on positive trends while managing risks effectively.