EuropeanNov 12 2014

Japanisation fears

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How can we justify benchmark German bond yields at 0.7 per cent, the lowest in their recorded history? This is a key question for investors to address, not just in relation to their holdings of eurozone assets. The implication of what is happening in Europe will matter considerably for other regions into 2015.

Many explanations have been put forward for the violent market corrections in October, but one area does appear to be the epicentre – namely Europe. Worries about the strength of the German economy, combined with fears about the lack of reforms in France and Italy, plus the stirring of political tensions in Greece, all caused investors to pull risk off the table, hence the DAX index falling almost 15 per cent peak to trough. Stepping back, German bond yields started the year at 2 per cent, so today’s levels of about 0.8 per cent leave them only 0.4 per cent above those offered in Japan. Is Europe entering ‘Japanisation’, an entrenched period of deflation?

Stepping back from the problems of 2014, let us look over the past few years. A new regime has appeared, one where asset prices are increasingly driven or determined by official edict rather than by the voluntary decisions of buyer and seller. Quantitative easing – unconventional monetary policy altering the normal demand and supply balance in government bond markets – has serious implications for capital flows. Yes, there are retail and institutional investors who build up capital or look for income opportunities. After all, current European yields are still positive in real terms against the backdrop of eurozone headline inflation, which is only running at 0.3 per cent a year. However, there are many investors, whether sovereign wealth funds, central bank foreign exchange reserve managers, or pension fund trustees, whose freedom of manoeuvre is seriously limited by this new set of rules. QE has raised the prices of many assets well away from fair value. We have to remember that, ultimately, we are trying to create decent nominal and inflation-adjusted returns for our clients. This is proving difficult in many areas of fixed income; at the time of writing, 10-year government bond yields are not only low in Japan and Germany, but also the US and UK, not far above 2 per cent. What sort of long-term returns can be expected from investing in such expensive assets?

A simple way of answering this question is not to look at Europe, but ask whether or not the Bank of England’s Monetary Policy Committee and the US Federal Reserve are actually able to start raising interest rates in 2015. If they can, then their business cycles have allowed sufficient growth and wages or consumer inflation to appear. On that basis, the medium-term assessment would be for rather higher bond yields – at its simplest, 2 per cent trend growth plus 2 per cent core inflation plus a risk premium would suggest US and UK bond yields broadly double their current levels.

Correlations between global bond markets remain rather tight. The implications of US and other global developments are rather important for Europe. Shifts in monetary policy expectations are already causing the Euro to depreciate. This should begin to affect import prices, helping to drive eurozone inflation back towards 1 per cent a year for 2015, as well as supporting stronger exports to a thriving US consumer. The uptrend should be helped especially by the rise in German minimum wages from January 2015 which will have a noticeable effect on the consumer price index. Second, the latest demand/supply shift in the oil market has caused a fall in prices. This will also have implications for the CPI, which needs assessing, but on balance it should feed through into higher real wages and thus consumer spending, as well as better margins for European companies. Lastly, there is the potential for European credit growth to pick up into 2015. The European Central Bank’s comprehensive assessment could – finally – start a process whereby lenders are more willing to extend borrowing, helped by the targeted longer-term refinancing operations measures introduced by the central bank. All in all, even in Europe, a successful ECB engineering some expansion in inflation back towards target rather than towards zero would expect to see mainstream eurozone bond yields closer to 2 per cent than 1 per cent.

QE is clearly one driver of the current low level of yields. Many hedge funds and investment banks are loudly calling for the ECB to extend QE to government debt. The arguments are rather more subtle, though, than many commentators suggest. For example, the ECB is already beginning to buy certain private-sector assets, such as covered bonds, asset-backed securities and potentially, corporate bonds. There are implications for the quality of the ECB’s balance sheet, which will concern many German policymakers. Nevertheless, reducing the spread between private and public sector bonds, as well as stimulating more securitisation by European banks, could give the ECB rather more bang for its buck.

The counter argument is that flows into bonds are not being driven by a mixture of short-term risk aversion plus central bank purchases. Instead they are correctly pricing in a more dangerous phenomenon, namely that the world economy is becoming trapped in a sustained period of very low economic growth and debt deleveraging after the financial crisis. Secular stagnation means QE has tried and failed. On that basis, neither the MPC nor the Fed manages to raise interest rates in 2015 as their economies do not reach “escape velocity”. The strength of domestic consumer spending and business investment is more than offset by the drag from weakness in Europe, Japan, the Brics and a decelerating China.

On this basis, we would expect to see the dash for yield to accelerate. The ECB’s attempts to limit its purchases to private-sector assets would be swamped by calls for wholesale buying of government debt, despite any German opposition. As the short end of the bond curve is already expensive, and indeed could well sell off, so there would still be value in long-dated bonds – the German 30-year bond yields about 1.8 per cent, with peripheral yields also attractive, and Italian 10-year debt currently yields 2.5 per cent. High-yield corporate and emerging market debt would respond, as would selected higher-yielding equities and real-estate assets to those investors searching for yield, in Europe or other regions. Expensive valuations would move higher.

To sum up, what kind of investment prospects do European bonds have in this environment? We consider that they are particularly expensive. The drivers of low European bond yields are clear – weak economic growth and low rates of inflation, plus expectations of QE by the ECB. As and when the economic news flow becomes more positive, in Europe or its major trading partners, recognising that Europe will not drift into deflation in 2015, and also that the news about QE is priced in, then a reassessment will turn sentiment, especially in the more expensive parts of the European bond market such as Germany.

Andrew Milligan is head of global strategy at Standard Life Investments

Key points

* Worries about the strength of the German economy, combined with fears about the lack of reforms in France and Italy caused investors to pull risk off the table in October.

* Correlations between global bond markets remain rather tight.

* QE is clearly one driver of the current low level of yields.