A global slowdown in 2019 – is it already in the price?

A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

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Italy and the repricing of European government debt

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Macro Letter – No 98 – 08-06-2018

Italy and the repricing of European government debt

  • The yield spread between 10yr BTPs and Bunds widened 114bp in May
  • Populist and anti-EU politics were the catalyst for this repricing of risk
  • Spain, Portugal and Greece all saw yields increase as Bund yields declined
  • The ECB policy of OMT should help to avoid a repeat of 2011/2012

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets. I will freely admit that this has led me to make a number of investment mistakes, although these have generally been sins of omission rather than actual investment losses. The Italian political situation and the sharp rise in Italian bond yields it precipitated, last week, is, therefore, some justification for an investor like myself, one who has not held any fixed income securities since 2010.

An excellent overview of the Italian political situation is contained in the latest essay from John Mauldin of  Mauldin Economics – From the Front Line – The Italian Trigger:-

Italy had been without a government since its March 4 election, which yielded a hung parliament with no party or coalition holding a majority. The Five Star Movement and Lega Nord finally reached a deal, to most everyone’s surprise since those two parties, while both broadly populist, have some big differences. Nonetheless, they found enough common ground to propose a cabinet to President Sergio Mattarella.

Italian presidents are generally seen as rubberstamp figureheads. They really aren’t supposed to insert themselves into the process. Yet Mattarella unexpectedly rejected the coalition’s proposed finance minister, 81-year-old economist Paolo Savona, on the grounds Savona had previously opposed Italy’s eurozone membership. This enraged Five Star and Lega Nord, who then ended their plans to form a government and threatened to impeach Mattarella.

The whole article is well worth reading and goes on to look at debt from a global perspective. John anticipates what he calls, ‘The Great Reset,’ when the reckoning for the excessive levels of debt arrives.

Returning to the repricing of Eurozone (EZ) debt last month, those readers who have followed my market commentaries since the 1990’s, might recall an article I penned about the convergence of European government bond yields in the period preceding the introduction of the Euro. At that juncture (1998) excepting Greece, every bond market, whose government was about to adopt the Euro, was trading at a narrower credit spread to 10yr German bunds than the yield differential between the highest and lowest credit in the US municipal bond market. The widest differential in the muni-market at that time was 110bp. It was between Alabama and California – remember this was prior to the bursting of the Tech bubble.

In my article I warned about the risk of a significant repricing of European credit spreads once the honeymoon period of the single currency had ended. I had to wait more than a decade, but in 2010/2011 it looked as if I might be vindicated – this column is not entitled In the Long Run without just cause – then what one might dub the Madness of Crowds of Central Bankers intervened, saved the EZ and consigned my cautionary oracles, on the perils of the quest for yield, to the dustbin of history.

In the intervening period, since 2011, I have watched European yields inexorably converge and absolute yields turn negative, in several EZ countries, with a temerity which smacks of permanence. I have also arrived at a new conclusion about the limits of credit risk within a currency union: that they are governed by fiat in much the same manner as currencies. As long as the market believes that Mr Draghi will do, ‘…whatever it takes,’ investors will be enticed by relatively small yield enhancements.

Let me elaborate on this newly-minted theory by way of an example. Back in March 2012, Greek 10yr yields reached 41.77% at that moment German 10yr yields were a mere 2.08%. The risk of contagion was steadily growing, as other peripheral EZ bond markets declined. Greece, in and of itself, was and remains, a small percentage of EZ GDP, but, as Portuguese and Spanish bonds began to follow the lead of Greece, the fear at the ECB – and even at the Bundesbank – was that Italy might succumb to contagion. Due to its size, the Italian bond market, was then, and remains today, the elephant in the room.

During the course of last month, European bond markets diverged. The table below shows the change in 10yr yields between 1st and 31st May:-

EZ 10yr yield change May 2018

Source: Investing.com

A certain degree of contagion is evident, although the PIGS have lost an ‘I’ as Irish Gilts have escaped the pejorative acronym.

At the peaks of the previous crisis, Irish 10yr Gilts made a yield high of 14.61% in July 2011, at which point their spread versus 10yr Bunds was 11.34%. When Italy entered her own period of distress, in November of that year, the highest 10yr BTP yield recorded was 7.51% and the spread over Germany reached 5.13%. By the time Greek 10yr yields reached their zenith, in March 2012, German yields were already lower and Irish and Italian spreads had begun to narrow.

During the course of last month the interest rate differential between 10yr Bunds and their Irish, Greek and Italian counterparts widened by 41, 100 and 114bp respectively. Italian 10yr yields closed at 4.25% over Bunds, less than 100bp from their 2011 crisis highs. With absolute yields significantly lower today (German 10yr yields were 2.38% in November 2011 they ended May 2018 at 36bp) the absolute percentage return differential is even higher than during the 2011 period. At 2.72% BTPs offer a return which is 7.5 times greater than 10yr Bunds. Back in 2011 the 7.51% yield was a little over three times the return available from 10yr Bunds.

I am forced to believe the reaction of the BTP market has been excessive and that spreads will narrow during the next few months. If I am incorrect in my expectation, it will fall to Mr Draghi to intervene. The Outright Monetary Transactions – OMT – policy of the ECB allows it to purchase a basket of European government bonds on a GDP weighted basis. If another crisis appears immanent they could adjust this policy to duration weight their purchases. It would then permit them to buy a larger proportion of the higher yielding, higher coupon bonds of the southern periphery. There would, no doubt, be complaints from those countries that practice greater fiscal rectitude, but the policy shift could be justified on investment grounds. If the default risk of all members of the EZ is equal due to the political will of the European Commission, then it makes sense from an investment perspective for the ECB to purchase higher yielding bonds if they have the same credit risk. A new incarnation of the Draghi Put could be implemented without too many objections from Frankfurt.

Conclusions and investment opportunities

I doubt we will see a repeat of the 2011/2012 period. Lightening seldom strikes twice in the same way. The ECB will continue with its QE programme and this will ensure that EZ government bond yields remain at artificially low levels for the foreseeable future.

Unusually, I have an actionable trade idea: caveat emptor! I believe the recent widening of the 10yr Italian BTP/Spanish Bonos spread has been excessive. If there is bond market contagion, as a result of the political situation in Italy, Bonos yields may have difficulty defying gravity. If the Italian political environment should improve, the over-sold BTP market should rebound. If the ECB are forced to act to avert a new EZ crisis by increasing OMT or implementing a duration weighted approach to QE, Italy should benefit more than Spain until the yield differential narrows.

Is the US exporting a recession?

Is the US exporting a recession?

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Macro Letter – No 96 – 04-05-2018

Is the US exporting a recession?

  • The Federal Reserve continue to raise rates as S&P earnings beat estimates
  • The ECB and BoJ maintain QE
  • Globally, corporations rely on US$ financing, nonetheless
  • Signs of a slowdown in growth are clearer outside the US

After last week’s ECB meeting, Mario Draghi gave the usual press conference. He confirmed the continuance of stimulus and mentioned the moderation in the rate of growth and below-target inflation. He also referred to the steady expansion in money supply. When it came to the Q&A he revealed rather more:-

It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries.

It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators. Sharp declines were experienced by PMI, almost all sectors, in retail, sales, manufacturing, services, in construction. Then we had declines in industrial production, in capital goods production. The PMI in exports orders also declined. Also we had declines in national business and confidence indicators.

I quote this passage out of context because the entire answer was more nuanced. My reason? To highlight the difference between the situation in the EU and the US. In Europe, money supply (M3) is growing at 4.3% yet inflation (HICP) is a mere 1.3%. Meanwhile in the US, inflation (CPI) is running at 2.4% and money supply (M2) is hovering a fraction above 2%. Here is a chart of Eurozone M3 since 1999:-

EU M3 Money Supply

Source: Eurostat

The recent weakening of momentum is a concern, but the absolute level is consistent with a continued expansion.

Looked at over a rather longer time horizon, here is a chart of US M2 since 1900:-

M2 since 1900 - Hoisington

Source: Hoisington Asset Management, Federal Reserve

The letters A, B, C, D denote the only occasions, during the last 118 years, when a decline in the expansion (or, during the 1930’s, contraction) of M2 did not lead to a recession. 17 out of 21 is a quite compelling record.

Another concern for markets is the flatness of the US yield curve. Here is the 2yr – 10yr yield differential since 1990:-

US 2yr - 10yr Factset Mauldin

Source: Factset, Mauldin Economics

More importantly, for international borrowers, the 6-month LIBOR rate has risen by more than 60 basis points since the start of the year (from 1.8% to 2.5%) whilst 30yr Swap rates have increased by only 40 basis points (2.6% to 3%). The 10yr – 30yr Swap curve is now practically flat.

Also worthy of comment, as US Treasury yields have risen, the relationship between Bonds and Swaps has begun to normalise – 30yr T-Bond yields are only 40 basis points above their level of January and roughly at the same level as in the spring of last year. In April 2017 I wrote in Macro Letter – No 74 – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?:-

Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.

It looks like I may have to eat my words, here is the Bond vs Swap table revisited:-

Evolution_of_T-Bond_and_IRS_Spreads_-_investing_co_002

Source: Investing.com, Interestrateswaps.com, BBA

What is evident is that the Bond/Swap inversion in the longer maturities has closed substantially even as shorter maturity spreads have narrowed. Federal Reserve policy has been the dominate factor.

Why is it, however, that the effect of higher US rates is, seemingly, felt more poignantly in Europe than the US? Does this bring us back to protectionism? Perhaps, but in less contentious terms, the US has run a capital account surplus for many years. Outside the US investment is closely tied to LIBOR financing costs, these have remained higher, except in the longest maturities, and these rates have risen most precipitously this year. Looked at another way, the higher interest rate policies of the Federal Reserve, despite the continued largesse of other central banks, is exporting the next recession to the rest of the world.

I ended Macro Letter – No 74 back in April 2017 – saying:-

Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long-term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.

One year on, cracks in the capital markets edifice are beginning to become more evident. GDP growth has started to rollover in the US, Eurozone and Japan. Yields are still relatively low but the absolute increase in rates for shorter maturities (e.g. the near doubling of US 2yr yields from 1.25% to 2.5% in a single year) is guaranteed to take its toll on corporate interest servicing costs. US capital markets are the envy of the world. They are deep and allow borrowers to finance far into the future. The rest of the world is forced to borrow at shorter tenors. A three basis point narrowing of 5yr spreads between Swaps and Bonds is hardly compensation for the near 1% increase in interest rates, or, put in starker terms, a 46% increase in absolute borrowing costs.

Conclusion and investment opportunities

How is the rise in borrowing costs impacting the US stock market? Volatility is back, but earnings are robust. Factset – S&P 500 Earnings Season Update: April 27, 2018 – described it thus:-

To date, 53% of the companies in the S&P 500 have reported actual results for Q1 2018. In terms of earnings, more companies are reporting actual EPS above estimates (79%) compared to the five-year average. If 79% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting actual EPS above estimates since FactSet began tracking this metric in Q3 2008. In aggregate, companies are reporting earnings that are 9.1% above the estimates, which is also above the five-year average. In terms of sales, more companies (74%) are reporting actual sales above estimates compared to the five-year average. In aggregate, companies are reporting sales that are 1.7% above estimates, which is also above the five-year average. If 1.7% is the final percentage for the quarter, it will mark the largest revenue surprise percentage since FactSet began tracking this metric in Q3 2008.

… The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the first quarter is 23.2% today, which is higher than the earnings growth rate of 18.5% last week. Positive earnings surprises reported by companies in multiple sectors (led by the Information Technology sector) were responsible for the increase in the earnings growth rate for the index during the past week. All 11 sectors are reporting year-over-year earnings growth. Nine sectors are reporting double-digit earnings growth, led by the Energy, Materials, Information Technology, and Financials sectors.

We are more than halfway through Q1 earnings (I’m writing this letter on Wednesday 2nd May). Results have generally been above forecast and now the Fed seems conscious that they must not be too hasty to reverse the effects of both zero rates and QE. Added to which, while US stocks have been languishing mid-range, European stocks have recently broken out of their recent ranges to the upside, despite discouraging economic data.

The US stock market looks less expensive than it did in January 2017, when I wrote Macro Letter – 68 – Equity valuation in a de-globalising world. Then I was looking for stock markets with a low correlation to the US: they were (and remain) hard to find.

Other indicators to watch which exert a strong influence on stocks include the US PMI Index – last at 54.8 up from 54.2 in March. Above 50 there is little cause for concern. For the Eurozone it is even higher at 55.2, whilst throughout G20 no economy is recording a PMI below 50.

The chart below shows the Citigroup Economic Surprises Index (blue) vs the S&P500 Forward P/E estimates (red):-

Citi Economic Surprises vs SandP - Yardeni 27-4-18

Source: Yardeni Research, S&P, Thompson Reuters, Citigroup

Economic surprises remain positive rather than negative for the US. In the Eurozone it is quite another matter:-

Citigroup Economic Surprises Index - Eurozone

Source: Bloomberg, Citigroup

A number of economic indicators are pointing to a slowdown, yet US stocks are beating estimates. To judge from price action, the market appears to be unimpressed by earnings. I am reminded of the old adage, ‘When all the buyers are in the market it’s time to sell.’ From a technical perspective it makes sense to be patient, but the market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

A safe place to hide – inflation and the bond markets

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Macro Letter – No 91 – 16-02-2018

A safe place to hide – inflation and the bond markets

  • US bond yields have risen from historic lows, they should rise further, they may not
  • The Federal Reserve is beginning to reduce its balance sheet other CBs continue QE
  • US bonds may still be a safe haven but a hawkish Fed makes short duration vulnerable
  • Short dated UK Gilts make be a safe place to hide, come the correction in stocks

US Bonds

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993

Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.

More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19th October 1955:-

If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.

Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-

US Inflation and 10yr bond yield 1950 to 1973

Source: Trading Economics

I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.

Central Bank balance sheets

Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-

CB_Balance_Sheets_-_Yardeni

Source: Haver Analytics, Yardeni Research

Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-

US_debt_ownership_Dec_2016

Source: US Treasury

As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.

Bond Markets in Europe and Japan

The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.

Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-

Germany vs Greece 10yr yields

Source: Trading Economics

By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.

Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.

The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.

Conclusions and Investment Opportunities

From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.

As a defensive investment one should look for short duration bonds, but in the US this brings the investor into conflict with the hawkish policy stance of the Fed; that is, what my friend Ben Hunt of Epsilon Theory dubs, the Inflation Narrative. For a contrary view this Kansas City Fed paper may be of interest – Has the Anchoring of Inflation Expectations Changed in the United States during the Past Decade?

In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-

united-kingdom-2-year-note-yield - 5yr

Source: Trading Economics

UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.

With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.

European Bonds – warning knell or cause for celebration?

European Bonds – warning knell or cause for celebration?

400dpiLogo

Macro Letter – No 85 – 13-10-2017

European Bonds – warning knell or cause for celebration?

  • Greek bonds have been the best performer in the Eurozone year to date
  • IMF austerity is still in place but there are hopes they will relent
  • Portuguese bonds have also rallied since March whilst Spanish Bonos declined
  • German Bund yields are up 28bps since January heralding an end to ECB QE

Writing, as government bond yields for peripheral European markets peaked in Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? I felt that another Eurozone crisis could not be ruled out:-

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016.

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Greece vs Germany 10yr yield 2017

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Bond_yields_Jan_vs_October_2017 (1)

Source: Investing.com

This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

Where now for European bonds?

A good place to start when attempted to divine where the European bond markets may be heading is by considering the outcome of the German election. Wolfgang Bauer of M&G Bond Vigilantes – Angela Merkel’s Pyrrhic victory – writing at the end of last month, prior to the Catalan vote, takes up the story:-

Populism is back with a vengeance

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

European Unemployment - BNP Paribas

Source: BNP Paribas Asset Management, Datastream

The rate of economic expansion in European is increasing and measures of the popularity of the Eurozone look robust. Nathalie Benatia of BNP Paribas – Yes, Europe is indeed back puts it like this:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

EZ survey July 2017

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-

Euro_Bond_spreads_2009_versus_2017

Source: Investing.com

Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.