Tantrum II and Euro­pean port­fo­lios

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

The cu­ri­ous thing about the bond mar­ket tantrum of the last two weeks is that it hap­pened de­spite big economies such as the US and China re­port­ing weak growth. More­over, the av­er­age bond yield across the G7 has bolted 50bp higher de­spite none of the G7 cen­tral banks an­nounc­ing a mean­ing­ful shift in their mon­e­tary pol­icy set­tings. Th­ese vi­o­lent mar­ket moves have three im­me­di­ate driv­ers with a big­ger secular fac­tor lurk­ing in the back­ground.

Oil’s surge from $46 in early Jan­uary to $65 has rekin­dled in­fla­tion ex­pec­ta­tions in Europe af­ter they flirted with record lows. Over the last six months a sim­i­lar shift has hap­pened in the US; Last Fri­day’s jobs re­port may have pro­duced head­lines for weak wage growth, yet viewed more broadly, earn­ings are clearly im­prov­ing.

The re­vival of bank lend­ing has been con­firmed in the US and most re­cently in Europe, which im­plies that fi­nan­cial sys­tems have less need of ven­ti­la­tor sup­port from cen­tral banks.

Volatil­ity re­sulted from funds re­vers­ing highly lever­aged po­si­tions on Euro­pean bonds that were taken out in ex­pec­ta­tion of the spread tight­en­ing im­pact of quan­ti­ta­tive eas­ing.

It is not clear that this mar­ket episode points to any­thing

1) In­fla­tion ex­pec­ta­tions:

2) Bank credit growth:

3) Hedge fund un­wind­ing:

sin­is­ter. In May 2013, con­cerns over US mon­e­tary pol­icy nor­mal­i­sa­tion caused the “ta­per tantrum”, but pretty soon af­ter the mar­ket set­tled. Cat­a­lysts #1 and #2 above both rep­re­sent good news as they im­ply that re­fla­tion­ary poli­cies are work­ing. Also, nom­i­nal long-term in­ter­est rates re­main low at 0.65% in Ger­many, less than 1% in France and 2.2% in the US, while pretty much ev­ery­where, else real rates are ei­ther neg­a­tive or barely pos­i­tive.

And this brings us to the big­ger point that may un­der­lay re­cent ruc­tions. If re­fla­tion­ary moves are con­firmed as hav­ing worked, then it will mean that the secular decline in G7 in­ter­est rates found a bot­tom early this year. The im­pli­ca­tion for port­fo­lio man­age­ment could be pro­found. In re­cent decades, in­vestors have been able to run a bal­anced port­fo­lio in the knowl­edge that bonds would likely come to the res­cue of volatile eq­uity mar­kets. This was es­pe­cially the case af­ter 2000 as eq­ui­ties on av­er­age de­liv­ered medi­ocre per­for­mance. Hence, if the secular bull mar­ket in bonds has in­deed reached its de­noue­ment then wealth man­agers will hence­forth need to make far more use of cash, rather than us­ing bonds as the de­fault buf­fer to ab­sorb shocks.

To be sure, there are rea­sons in Europe to think that such a shift could be a slow mo­tion af­fair. The Euro­pean Cen­tral Bank will main­tain its de­posit rate at -20pbs for the fore­see­able fu­ture, so an­chor­ing the short-end of the curve. Un­der its QE pro­gramme the ECB will con­tinue to buy an av­er­age EUR 45 bln of gov­ern­ment bonds each month un­til Septem­ber 2016. It would be sur­pris­ing if Mario Draghi does not re­as­sure on th­ese points in the com­ing weeks.

Lastly, the yield dif­fer­en­tial be­tween pe­riph­eral eu­ro­zone economies and Ger­many re­mains at­trac­tive; in the case of Spain the spread at the 30-year ma­tu­rity is 160bp de­spite credit risk in that econ­omy be­ing greatly re­duced. Im­proved fun­da­men­tals in South­ern Europe can be seen by an im­proved jobs pic­ture in Spain and the Por­tu­gal, while in Italy, busi­ness sur­veys point to an eco­nomic ac­cel­er­a­tion. How­ever, the “good news” for bond in­vestors is that this mild re­cov­ery in the South is a long way from gen­er­at­ing a wage spi­ral.

Our con­clu­sion would thus be to stay long Euro­pean eq­ui­ties, es­pe­cially the banks, as a play on the re­fla­tion theme. In­vestors should stay long pe­riph­eral bonds, but sell bunds on strength.

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