European fixed income outlook—cautious optimism

David Zahn, Head of European Fixed Income, is cautiously optimistic about Europe’s economic outlook in 2026. In his view, German fiscal stimulus should have a material impact on both domestic growth and the broader region’s prospects. Challenges remain in some countries, given domestic political pressures, while geopolitics present an obvious macro risk. Nonetheless, stronger growth, contained inflation and stable monetary policy provide the conditions for a broadly constructive European fixed income investment environment. That said, a focus on valuations will likely determine a carefully considered approach.

The European Central Bank (ECB) cut rates aggressively in the first half of 2025 as part of its efforts to normalise monetary policy. The transmission effects of policy easing have started to feed into the real economy, with eurozone activity picking up in the second half of 2025, despite US tariffs, due to a recovery in domestic demand. This momentum is expected to be sustained, with eurozone growth estimated to increase to 1.4% of gross domestic product (GDP) in 2026 and to approximately 1.6% in 2027.¹ With inflation now close to 2%, broadly in line with the ECB’s target, we expect the central bank to remain on hold for some time. Inflation has been brought under control—at least for now.

Pivotal to the stronger growth outlook will be whether Germany resumes its role as the principal driver of the eurozone economy, after experiencing broadly flat growth in recent years. We believe that the signs are encouraging.

Economic sentiment has improved since the announcement of a sizeable increase in fiscal spending: a €500 billion Special Fund for Infrastructure and Climate Transformation over 12 years (equating to approximately 11.5% of 2024 German GDP) and defence spending above 1% of GDP to be excluded from the so-called “debt brake” fiscal rules. In addition, the fiscal rules have been eased to exclude structural borrowing for the German regional states (Länder) up to 0.35% of their GDP annually. Given the scale and long-term nature of these measures, we expect the growth impact could be meaningful and prove relatively sustainable, generating positive spillover effects across the wider eurozone.

Indeed, despite Germany’s improving prospects, other core European economies remain comparatively weak. France remains in a state of political paralysis, with the 2026 budget yet to be resolved. Although the French National Assembly passed an emergency bill towards the end of 2025 to support government finances, more substantial action will be required. The budget deficit in 2025 reached 5.4% of GDP and we believe is unlikely to fall below 5% in 2026, with growth expected to remain weak, around 1% in 2026. Moreover, any fiscal progress is likely to be stymied as attention turns to the 2027 presidential elections, which will no doubt prolong the political turbulence.

In many ways, the eurozone today represents an inversion of the pre-global financial crisis period, when core economies were strong and peripheral countries struggled. Several former peripheral economies are among the stronger performers, with sovereign rating upgrades in Spain, Italy and Portugal during 2025, in contrast to rating downgrades for France, Belgium and Austria. Notably, Spain has made tangible progress in improving its public finances and reducing its budget deficit, which is expected to end 2025 at 2.5% of GDP.² Strong consumption and supportive supply-side factors, such as higher immigration, have contributed to the Spanish economy’s outperformance relative to peers (2.8% year-over-year in the third quarter³), and this trend is expected to be maintained over the next year.⁴

From a sector standpoint, Europe’s defence sector is likely to be a key focus for growth and expansion in the coming years, with this urgency increasing following concerns about Greenland and a potential fracturing of the North Atlantic Treaty Organization alliance. Against a backdrop of elevated geopolitical uncertainty—and with Europe increasingly unable to rely on the United States as the world’s primary security guarantor—we may see renewed efforts to build a more integrated European defence capability. The region’s defence industry remains highly fragmented, with the United Kingdom hosting the largest number of defence companies and accounting for the highest share of industry sales in Europe (approximately 25%).⁵ Defence spending across Europe is already rising, and we expect the coming decades to see a significant expansion of the sector, with positive spillovers for related industries, such as technology.

Based on our expectation that the eurozone region is likely to benefit from a German-led growth uplift, this leaves the question as to whether fiscal expansion translates into higher inflation. Recent prints have surprised on the downside, due to lower energy and food prices, although services inflation remains elevated. Overall, though, we expect eurozone inflation to remain slightly below the ECB’s 2% target throughout 2026. The legacy impact of stronger euro should help to suppress price pressures, in addition to normalising wage growth and relatively low energy prices, which has been mainly due to a rising oil-supply balance. However, we are mindful of energy prices’ vulnerability to a rising geopolitical risk premium. Counterintuitively, US tariffs could further suppress price pressures as China increasingly targets non-US export markets, although the data, so far, has not shown any strong evidence.

What does our macroeconomic outlook imply for eurozone yield curves?

We expect a curve steepening bias to be maintained, although focused between the intermediate- and long-dated sectors. This expectation reflects the substantial volume of government bond issuance forecast for 2026—notably from Germany—that will likely exert upward pressure on long-term yields. At the same time, demand for longer-dated bonds may weaken due to regulatory shifts. Dutch pension funds, historically major buyers of long-duration bonds, are transitioning from defined benefit to defined contribution schemes, reducing their need for long-dated assets. A key source of demand is expected to diminish, implying a higher-term premium than in the past.

Investors’ perceptions of ECB policy further out also supports our preference for the intermediate-dated sector. While we expect the ECB to remain on hold for an extended period, the possibility of rate hikes cannot be ruled out, particularly in early 2027 if growth improves as anticipated. Bond investors are beginning to tentatively price in this risk.

Outside of sovereigns, credit markets tend to benefit from a moderate growth backdrop. However, tight valuation levels keep us cautious, and we are maintaining light credit exposure within our portfolios. With spreads at multi-year lows, we believe that much of this optimism has already been priced across the quality spectrum. Even in euro high yield, we assess that valuations do not adequately compensate investors for the risks, given the overall improvement in quality, indicated by 70% of issuance currently rated BB.⁶ Credit markets could be vulnerable to higher levels of volatility in 2026, leaving scope for some spread widening that could present opportunities to add exposure selectively over time.

Finally, from a currency perspective, we expect some modest appreciation of the euro in 2026, given ongoing pressures on the US dollar and concerns about institutional governance. However, we believe that the euro is fairly valued following a strong performance in 2025. More attractive opportunities may lie in currencies such as the Norwegian krone, Swedish krona and Polish zloty. Norway’s growth outlook remains solid, supporting a “higher for longer” rate environment. Sweden’s open economy stands to benefit from improving European growth, while Poland, as the largest economy in central Europe, remains closely linked to Germany’s fortunes. As rates rise, we expect these currencies to appreciate gradually over the next six to 12 months.

Overall, we are cautiously optimistic about the year ahead, given an uplift to eurozone growth prospects amid moderate inflation trends. Headline political noise may cause some volatility, and we are seeking to keep our portfolios defensively positioned, focusing on intermediate-dated maturities. This stance should provide flexibility to potentially capture selective valuation opportunities, which we believe is particularly supportive of our active management approach.