TT explains the recent bond market ructions before considering the potential impact on equities.
For most of 2015 German 10-year bond yields had been heading calmly towards zero. Shorter-term bunds were already offering negative yields, meaning that investors who held the debt to maturity were certain to lose money. Then everything changed. In the middle of April, bond markets quaked violently. German 10-year yields were jolted from a record low of 0.05% to a 5-month high of 0.80% in just three weeks. Plummeting prices wiped out more than 60 years’ worth of income – the biggest rout in total return terms since 1994. Though German bunds were at the epicentre, aftershocks were quickly felt around Europe. French, Italian, Spanish and Portuguese bonds all sold off sharply, erasing the hard-won gains in yield compression achieved since the announcement of quantitative easing.
10-year government bond yields (%)
Source: TT International, Bloomberg
Tremors of this magnitude are rare in government bond markets. Investors were left nursing paper losses approaching half a trillion dollars. More damage was inflicted as the bond rout exacerbated shockwaves already reverberating around other markets. US treasuries and the dollar came under heavy selling pressure while crude oil and the euro surged, reversing some of the most lucrative trades this year. Interpreting the significance of these seismic events will define the success or failure of many fund managers over the coming months. So what caused the bond market chaos, and what are the implications for equities?
The origins of the bond market shock can be traced back to the summer of 2014, when oil prices suddenly collapsed. To counter the growing threat of deflation, the European Central Bank commenced a €1 trillion programme of sovereign bond purchases in early 2015.
This prompted frenzied speculation from investors who assumed that heavy buying from the ECB would create bond shortages, meaning that yields could only move lower. Much of the speculation centred on bunds, which were believed to have an added scarcity value, given Germany’s fiscal surplus.
Like bunds, the eurodollar was perceived to be a one-way trade. Conventional wisdom dictated that the ECB’s money-printing would hurt the euro, while a recovering US economy would spur early rate rises and strengthen the greenback. The overwhelming consensus was most obvious in futures. In late March, more money was bet on the euro tumbling than at the height of the eurozone debt crisis, when it was widely acknowledged that the single currency was doomed. With speculative positions building up like pressure on a fault line, debt and currency markets were vulnerable to a seismic shakeout.
The trigger was a swift rebound in oil prices, coupled with a sudden reversal in economic data that suggested growth in the US and Europe may actually converge. Once the shakeout began, it was amplified by a lack of liquidity. Indeed, higher capital requirements and controls on proprietary trading mean traditional market makers such as banks now withdraw more rapidly from stressed markets. They were probably joined in the stampede for the exit by increasingly prevalent passive investment vehicles that are often de facto momentum traders.
Tectonic shift in economic expectations
Excessive positioning and a lack of liquidity are parts of the story, but the bond market upheaval is also a reflection of an improving economic outlook. Investors are adjusting to the fact that the eurozone has avoided a damaging spell of deflation. One-year inflation expectations have spiked by almost 100 basis points since October. Longer-term expectations are also on the rise.
Eurozone 5-year inflation expectations (%)
Source: TT International, Bloomberg
Consequently, investors have begun dumping fixed-interest bonds that offer too little protection against inflation.
Higher inflation expectations are partly due to stabilising oil prices. Brent crude has surged nearly 40% since January and other commodities such as copper have risen in lockstep. But anticipation of greater pricing power is also an acknowledgement that the eurozone economic recovery is accelerating. GDP growth in the first quarter of 2015 was the fastest for nearly two years, with all four of the region’s largest economies recording growth for the first time since 2010. What’s more, the eurozone’s broad money supply has been expanding at an annualised pace of almost 8% over the past 6 months, suggesting the reflationary revival will accelerate further.
Eurozone M3 money supply (6 month annualised % change)
Source: TT International, Bloomberg
As the recovery gains traction, European bond yields – still astonishingly low across much of the region – should gradually move higher. However, a swift return towards levels considered normal before the Global Financial Crisis seems doubtful. With debt levels still extremely high, a vicious move in bond yields would crimp growth, ultimately defeating itself. Moreover, inflation expectations are unlikely to pick up significantly from here as the European recovery is still weak and oil prices face major headwinds. Oversupply has reached 2.1m barrels-a-day, while US shale operators say the price rally may allow them to keep increasing production, adding more black gold to an already saturated market.
A reflationary environment and an associated rise in bond yields will create shockwaves that ripple through equity markets. The same fear of deflation that drove bonds to record highs also triggered a flight to safety in equities, with defensive business models enjoying an unprecedented re-rating. This trend has probably peaked, meaning these companies will be relatively low returning investments and should be avoided. On the other hand, cyclical stocks should be favoured, especially those with undemanding valuations and improving earnings momentum – many Consumer Discretionary names fit the bill.
Domestic cyclicals are particularly attractive. It is interesting to note that domestically focused businesses have seen stronger sales and EPS beats than exporters in recent weeks. They also outperformed by a greater margin on results day, suggesting that investors are favouring beats that are more ‘organic’ than ‘FX-driven’. Despite this recent outperformance, domestics still trade at a 40% discount to their exporting peers.
European domestics trade at a deep discount to exporters
Source: Barclays Research
As key beneficiaries of rising bond yields, banks are another compelling proposition. They make most of their money on the spread between the short-term rate of interest they pay savers and the longer-term one they charge borrowers. This ‘net interest margin’ rises as the yield curve steepens, boosting profitability.
Of course, there is a risk that the reflation trade proves to be another false dawn. The European recovery remains fragile and could easily be choked off if yields rise too quickly. It has also benefited from a rare combination of supporting factors, including currency weakness, lower energy costs and loose monetary policy. A sustained reversal in any of these elements would undermine European growth. Greece is another concern. Though chances of a Grexit remain reasonably low, they are rising. In this scenario, Greece would return to a deep recession and eurozone membership would no longer be seen as irreversible, raising the prospect of further departures. While aware of these risks, our base case is that a gradual European recovery will see bond yields rise slowly, prompting a rotation in equity market leadership from defensives to cyclicals.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).