Germany’s fiscal shift: A boost for European credit?

This shift marks a notable departure from previous fiscal policies, reflecting a more expansive approach to address pressing issues and as a result stimulate economic growth. Consequently, Euro credit has strongly outperformed the US credit market since the fiscal spending was announced. Thanks to its strong European roots, Robeco is well-positioned to closely monitor developments and seize opportunities in credits.

The outlook for Germany’s fiscal expansion comes with uncertainty, particularly around execution and the fiscal multiplier. However, we believe the anticipated increase in infrastructure and defense spending will be a catalyst for growth in Germany and Europe, leading to improved corporate performance and bolstering the fundamentals of the European credit market. This increase in government spending should also result in a significant increase in German government debt issuance over the coming years. Higher economic growth and higher debt issuance are both likely to lead to structurally higher German bund yields.

In response to this policy shift, the 10-year Bund yield jumped by 40 bps and the yield curve has steepened, reflecting market expectations for higher future interest rates. While average yields of credit benchmarks are back at year-to-date highs, credit spread levels are approaching their post-GFC tights. Uncertainty around tariff headlines, the possible end of US exceptionalism, and references to a recession in the US may lead to the widening of European credit spreads in tandem with the US. On the other hand, if the new regime of more fiscal spending and looser budget policies leads to stronger growth, this would be supportive for credit and credit demand.

While the increase in German yields negatively affected total returns of euro-denominated credits, the higher yield levels could present a favorable technical factor and lead to inflows into the asset class going forward. The higher yield environment for European credits offers the potential for higher returns in the future. The total returns on US credits have remained positive as underlying risk-free rates declined. This may attract fund flows to US credits which could negatively weigh on European credits in the short run.

Until now, the convergence of European and US credit spreads has been advantageous for our global credit strategies as the decline in European spreads versus US spreads has been a major driver of outperformance in the year so far. Our overweight positions in euro-denominated credits have clearly benefited the performance, and therefore we have been gradually reducing this overweight to lock in the gains.

We anticipate that the announced surge in fiscal spending will have wide-ranging impacts across various sectors. The tailwinds of fiscal spending coupled with a broader defense spending boost should bode well for sectors that are positively correlated to domestic growth. German manufacturing, which has been in the doghouse for the last two years, could emerge as a beneficiary of Europe’s new spending policy. Cyclical sectors will tend to outperform more defensive sectors.

Infrastructure and defense: Companies in these sectors are likely to see a direct boost. This is particularly relevant as many European countries are focusing on upgrading their infrastructure and enhancing defense capabilities. Infrastructure-related sectors, like diversified manufacturing and building materials, represent roughly 3% of the euro credit market. The aerospace and defense sector is relatively small with EUR 17 billion in debt outstanding, limiting the room to play this sector actively.

European banks: Higher economic activity and a steeper yield curve will enhance bank profitability by improving net interest margins. Banks will benefit from increased lending opportunities and improved asset quality as the economy strengthens. This is already reflected in recent earnings calls and outlooks by management teams. An important sector in the European credit market, banking provides investment opportunities across the capital structure. At Robeco, we have deep expertise in financial credits including banks, evidenced by the track record of our Financial Institutions Bonds strategy. Furthermore, Robeco’s European and global credit strategies typically maintain significant allocations to financials, which has proven to be a strong source of alpha over 2023 and 2024.

On the flip side, some sectors may face challenges:
Real estate: Issuers in the real estate sector, particularly those that benefited from low rates, could struggle if yields remain elevated. Higher yields lead to higher borrowing costs and subsequently lower profit margins and less demand for real estate. This in turn may lead to declines in real estate valuations. While increased spending in infrastructure could benefit real estate, recent trading sessions have shown underperformance in this sector.

Highly leveraged firms: Companies with low credit ratings may start to face challenges in servicing their debt in case yields remain at elevated levels or even increase further.

However, we expect investment grade companies and solid BB-rated firms to weather the impact of rising yields without significant issues, thanks to robust fundamentals and prudent financial management. These segments represent the core of the allocations in our Euro Credit, Global Credit and Credit Income strategies.