Tantrum II and European portfolios
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.