The recent pullback in European bond markets may have dented some of the resurgent optimism towards the continent that has been taking hold this year. Now is a good time to ask whether the improvement in sentiment in Europe is merely a short-term high resulting from cheap currency and a rush of central bank liquidity or the beginning of a more lasting change. From a global standpoint, we also need to ask whether there will be a net improvement in global growth as a result of these developments or whether we are merely seeing growth redistributed from the US to Europe via the medium of exchange rate.
In the aftermath of the introduction of the European Central Bank’s ambitious quantitative easing programme, the proportion of eurozone sovereign bonds commanding negative yields peaked at 29 per cent in April before falling back sharply. Thanks to this recent sell-off, the share is now around 15 per cent, which is much higher than a year ago but still significant for any investor looking for “safe” assets with a positive return.
These downward moves in nominal bond yields in the eurozone were greeted enthusiastically by people who had worried about the likely effectiveness of ECB sovereign bond purchases in an environment in which borrowing costs in Europe were already so low. Recent work by the International Monetary Fund suggests currency and equity movements after the possibility of QE was first signaled by ECB president Mario Draghi in August 2014 were broadly similar to the impact of the first round of QE in the US, though recent market moves have somewhat offset this.
However, the experience of QE in these other cases also shows yields do not keep falling indefinitely. If the policy is successful, you should see inflation and growth expectations start to pick up, and nominal bond yields start to go higher as well. That is exactly what we have now seen.
It is probably too soon to say whether the European bond market has turned for good. However, with the oil price rebounding significantly since its low in early January and long-term inflation expectations starting to go back up, there is less fear of a prolonged period of outright deflation in Europe than at the start of the year. After the rout in European bond markets in late April and early May, there must also be fewer speculative buyers of German sovereign bonds under the impression the market is a one-way bet.
In local currency terms the total return on a 10-year German bund has been 0.10 per cent since the start of 2015 and 8.2 per cent over the past 12 months. The contrast with equities is instructive. While European equities have also retraced a lot of ground since the end of April, in local currency terms the main Eurostoxx index has produced a total return to investors of 21 per cent in the past 12 months. The German stock market has delivered a total return of 19 per cent since the start of the year.
Looking at the real economy, there is some support for the greater investor optimism we have seen, with European economies largely producing positive surprises since the start of the year, in contrast to the US.
There are other aspects of the European situation that are still cause for concern – notably the state of capital spending – but investors have good reason to feel more optimistic than they did.
So what does all of this mean for portfolios?
Notwithstanding the pullback in late April and early May, European equity markets have had a good run so far in 2015. This has raised valuations in a context in which corporate earnings have only just begun to recover. European earnings forecasts are now being revised upwards for the first time in many years. But the disappointing track record and the new higher level of European stocks also highlight the importance of selectivity and a focus on the fundamentals.
Investors also need to be alert to the way increased confidence in Europe’s recovery may feed through to different stocks and sectors. An example would be financial stocks: one of few sectors still significantly below their pre-crisis peak. QE is a tax on bank profitability because it flattens the yield curve and makes lending less profitable. As long as that is the dominant force moving market sentiment, we would not expect financial stocks to outperform. However, they are also the ultimate growth stock: if investors start to believe there is more to the European rally than QE and the currency, financial stocks should benefit disproportionately, even in the presence of continued QE.
The implications for fixed income are also nuanced but, in general, higher-risk assets should benefit from this lower-yield environment. While we believe there will be strong continued demand for European sovereign debt, the valuations do not look attractive on any traditional metric.
Stephanie Flanders is chief market strategist at JP Morgan Asset Management.