Euro credit: steady as fiscal support strengthens

This article is an extract from our Q1 2026 Active Fixed Income Outlook.

The past – what just happened?

The final quarter of 2025 saw European markets navigate a mix of stabilisation and surprise. After two interest rate cuts earlier in the year, the European Central Bank (ECB) paused in October, signalling a more cautious, data-driven approach as headline inflation eased but core measures remained sticky. This shift tempered expectations for further easing and added volatility to rates. Comments from Isabel Schnabel, one of the ECB members who is typically viewed to be more on the ‘hawkish’ side of spectrum, that she is “comfortable with investor bets that the ECB’s next interest-rate move will be an increase” appeared to confirm the end of the easing cycle, and pushed five-year German rates back up to 2.5%.

Bund yields moved down sharply in October following concerns about US credit and JP Morgan’s Jamie Dimon’s warning about “cockroaches” and future losses in the private credit sector. However, we saw this begin to reverse in November as fiscal policy stayed in focus with Germany accelerating infrastructure spending under its revised debt brake and France announcing a €15 billion green investment plan. These measures reinforced the theme of fiscal support as a counterbalance to monetary restraint.

Credit spreads proved resilient despite episodic volatility. Euro investment grade (IG) tightened by roughly 10 basis points over the quarter, supported by strong technicals and steady inflows even as supply remained heavy in September. October brought some widening on geopolitical risk and weaker guidance from cyclical sectors, but November stabilised as global risk appetite improved and US-EU trade rhetoric softened. Political noise persisted around EU budget negotiations and UK fiscal manoeuvres, but markets largely shrugged it off thanks to resilient fundamentals and demand for quality carry.

The present – positioning and performance

Momentum in European credit remains strong, and we are leaning into opportunities with conviction. Technicals are supportive, with inflows expected to continue through yearend and into early 2026. November was a blockbuster month for primary issuance, with over €108 billion of new deals, making it the highest November number ever and the third-busiest month on record. Despite the surge in supply, demand was strong, reflecting deep investor appetite and confidence in the European growth story.

Our strategy has been highly active and selective. We captured value in new issues that have already delivered solid performance, while tactical single-name positions such as Lanxess*, SES* and WPP* have added meaningful alpha. Closing credit default swap (CDS) shorts ahead of December reduced negative carry and positioned us for a cleaner start to the new year. Across portfolios, risk exposure mostly remained somewhat elevated at 5-10% but with a tilt towards better quality and defensive sectors.

We are not standing still. Sector rotation is in full swing: Autos have rallied hard and now look expensive, so we are reallocating towards banks, where we believe fundamentals and capital strength remain compelling. Financials in the upper capital structure continue to drive outperformance, supported by robust buffers and regulatory clarity. Avoiding earnings disappointments has also preserved relative returns. Positive carry remains a consistent engine of performance, and we are positioning to capture it without compromising on quality.

In short, we are combining strong technicals, disciplined risk management and targeted alpha strategies with the aim to keep performance resilient and forward-looking.

Outlook

At the start of 2026, Europe benefits from a stronger fiscal impulse and tentative signs of political cohesion aimed at sustaining growth through public investment. Volatility in risk markets, whether it is equity or credit, has largely settled down after the early April spike, and with rates now back to about 3.25% technicals are expected to remain supportive.

Some risks, however, remain unresolved. Tariff uncertainty, particularly around US-EU negotiations, continues to cast a shadow while geopolitical flashpoints could inject renewed volatility. The ECB’s data-dependent stance adds complexity as any upside surprise in inflation could challenge the current policy narrative and reprice duration risk. In addition, AI investment plans by the so-called hyperscalers have increased dramatically over the past six to 12 months and it’s increasingly clear that a substantial part will be financed through the debt markets. This is expected to mainly impact the dollar market, but the recent €12.5 billion issuance by Alphabet* signals how part of the supply percolates into the Euro market.

Longer term, caution prevails. Valuations leave little margin for error and the interplay between fiscal expansion and monetary restraint will shape the landscape in 2026. External shocks such as trade, politics or energy could quickly shift sentiment while uncertainty remains about credit quality in private markets, the sustainability of government deficits, and the impact of AI on productivity.

As a result, we have maintained our score of -1.

What could go wrong? 

• Growth risks: A sharper slowdown in global activity could reignite recession fears and pressure spreads.
• Inflation surprise: Any unexpected spike from energy shocks or wage dynamics could force central banks to pivot away from their dovish bias.
• Fiscal sustainability: Rising deficits and debt ratios may test investor confidence, with implications for sovereign spreads and funding costs.
• AI capex: Doubts about the scale and profitability of AI investment plans, with repercussions for equity valuations and future company cash flows.
• Fiscal sustainability: Rising deficits and debt ratios may test investor confidence with implications for sovereign spreads and funding costs.
• Geopolitical escalation: Conflicts in Ukraine or the Middle East, or new trade frictions, could disrupt markets and trigger risk-off behaviour.

This article is an extract from our Q1 2026 Active Fixed Income Outlook.

 

Assumptions, opinions, and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.

 *For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an L&G portfolio. The above information does not constitute a recommendation to buy or sell any security.