The pan­icked reach for yield

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Trav­el­ling around Europe in re­cent weeks, we have been struck by how chal­leng­ing most in­vestors are find­ing the un­prece­dented sit­u­a­tion cre­ated by the launch of the Euro­pean Cen­tral Bank’s quan­ti­ta­tive eas­ing pro­gram in the con­text of neg­a­tive bond yields in the core eu­ro­zone coun­tries. Th­ese dif­fi­cul­ties stem mainly from the con­tra­dic­tion be­tween in­vestors’ ur­gent need to reach for yield and the re­luc­tance of lo­cal reg­u­la­tors and risk man­agers to let them take on more risk. It ap­pears that Euro­pean fi­nan­cial in­sti­tu­tions find them­selves al­most as un­pre­pared for the end of the eu­ro­zone’s fi­nan­cial mar­ket cri­sis as they were when it started five years ago. The ma­jor im­pli­ca­tion is that over the com­ing quar­ters the enor­mous pools of dor­mant liq­uid­ity ac­cu­mu­lated dur­ing the euro cri­sis are go­ing to flow into eu­ro­zone and noneu­ro­zone mar­kets in suc­ces­sive waves. Europe’s liq­uid­ity boom has only just be­gun.

There has al­ways been a huge con­tra­dic­tion be­tween on one hand Basel III plus the EU’s Sol­vency II pro­vi­sions— which con­sider in­vest­ments in any gov­ern­ment bonds in the Euro­pean Eco­nomic Area as good as gold re­gard­less of rat­ings or other considerations—and on the other hand the ab­sence of a eu­ro­zone lender of last re­sort, which makes gov­ern­ment de­faults not only pos­si­ble but even likely. This in­con­sis­tency has now been re­moved, at least for the next cou­ple of years, thanks to ECB’s pro­gram of sovereign bond pur­chases that started this month.

But the fi­nan­cial in­dus­try finds it­self com­pletely wrong­footed, since over re­cent years risk man­agers, na­tional reg­u­la­tors and rat­ing agen­cies have caused in­vestors dramatically to nar­row their in­vestible uni­verse. This nar­row­ing has cre­ated huge reser­voirs of liq­uid­ity held in the so-called safe haven bonds of core Europe—bonds which are now in neg­a­tive yield ter­ri­tory. This is un­sus­tain­able, es­pe­cially for those in­sur­ers and pen­sion funds that have guar­an­teed min­i­mum re­turns of 2% or 3% to their clients.

How will the banks, in­sur­ers and pen­sions funds of Europe re­act to the shock? Their pan­icked reach for yield has al­ready led to some in­ter­est­ing ac­tiv­ity. For ex­am­ple, French in­sur­ers are re­ported to be bid­ding ag­gres­sively for struc­tured credit prod­ucts in­volv­ing loans to SMEs, while Ital­ian pen­sion funds are ask­ing the reg­u­la­tor for au­tho­riza­tion to buy more US trea­sury bonds. It is likely that news of this kind will abound over the next few months. One of the most in­ter­est­ing as­pects of the game may be played out in the Nether­lands. Dutch pen­sion funds and in­sur­ers hold al­most ?1.4trn in bonds and eq­ui­ties, more than a third of which is parked in core eu­ro­zone gov­ern­ment bonds. In­vest­ment in pe­riph­eral bonds is still stig­ma­tized by the lo­cal reg­u­la­tor, and pen­sion funds are highly sen­si­tive to rat­ings. The down­grades of Spain, Italy and other frag­ile coun­tries since 2010 means that 40% of eu­ro­zone gov­ern­ment debt is now rated be­low AA grade. Will the Dutch (and other) pen­sion funds have to wait for the no­to­ri­ously slow rat­ing agen­cies to up­grade the eu­ro­zone’s pe­riph­ery on the back of im­proved eco­nomic con­di­tions and lower bond yields? And where will they in­vest in the mean­time?

It is al­most cer­tain that the ex­pan­sion of the reach for yield be­yond the very long-end of the core eu­ro­zone yield curves has only just be­gun. In Europe’s cur­rent eco­nomic and mon­e­tary en­vi­ron­ment, there is lit­tle rea­son why Span­ish or even Por­tuguese bonds should yield sig­nif­i­cantly more than those of the core coun­tries. The reach for yield will most likely ex­tend fur­ther to the cor­po­rate bond uni­verse, where spreads re­main higher than in 2007. But it will also lead in­vestors to the US, the UK, Swe­den, Eastern Europe and Turkey. Last but not least, the juicy div­i­dend yields pro­vided by listed eq­ui­ties are now at­tract­ing new cat­e­gories of in­vestors, who are buy­ing div­i­dend only in­dices.

This eu­ro­zone liq­uid­ity boom has only just started. Along with the ECB’s daily pur­chase of bonds through Septem­ber next year, suc­ces­sive waves of liq­uid­ity are go­ing to flow into global mar­kets as eu­ro­zone fi­nan­cial in­sti­tu­tions open their flood­gates one af­ter the other. Un­der th­ese cir­cum­stances, it would be un­wise to read too much into rel­a­tive price move­ments, such as “cycli­cals ver­sus de­fen­sives”, or “growth ver­sus value”, as liq­uid­ity flows and a pan­icky reach for yield will dom­i­nate.

It would be mis­lead­ing, how­ever, to con­clude that Europe’s cur­rent bull mar­ket is only liq­uid­ity-driven. Firstly, re­cent in­di­ca­tions sug­gest that some of this liq­uid­ity is now go­ing to boost credit growth. Se­condly port­fo­lio re­bal­anc­ing is ex­pected to re­vive in­tra-eu­ro­zone ve­loc­ity, af­ter a six-year decline that went a long way to ex­plain the weak­ness of in­vest­ment in Europe. And fi­nally, the eco­nomic cy­cle in Europe now seems to be trend­ing firmly up­wards, as in­di­cated once again last week by a re­port show­ing that at 0.9% YoY in the fourth quar­ter of last year, em­ploy­ment growth in the eu­ro­zone has reached its high­est level since 2008.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.