Tuesday, October 21st, 2014


It’s a fair bet that most of our US subscribers never get round to looking at the asset allocation reports we prepare for our Eurozone clients. Why should they? What’s the point of looking at a report which has medium-dated German Bunds as the risk-free asset? Normally we would agree, but just at the moment something rather interesting is happening. Our European report recommends a weighting of 55% in the dollar-denominated bonds issued by Emerging Market countries. At face value this is absurd, because EM bonds are a small asset class, and this would represent an enormous overweight relative to any known benchmark. There is however an easy and important explanation.

None of our asset allocation models (dollar, sterling or euro) allow investors to own bonds issued by the government of another developed country. Thus, the euro model can only own Bunds, not Gilts or Treasuries or JGBs. This is a slightly arbitrary restriction which denies investors an opportunity they would sometimes consider in the real world, and we believe that now is one of those occasions. If we substitute US Treasuries for EM bonds, there is no shortage of eligible assets and our model would actually recommend a higher weighting because Treasuries have better risk-adjusted returns than EM bonds. In other words Eurozone investors don’t want exposure to Emerging Markets per se, what they want is low-risk exposure to the US dollar.

We only need to review the alternatives to see that Treasuries are the asset of choice. Eurozone equities have been hard hit by the downward revision of GDP targets for 2014 and (shortly 2015). UK equities are too closely correlated to offer much diversification. Japan and EM equities can only ever account for a small percentage of the whole portfolio. US equities have produced good returns in euro terms, but our models suggest that the best of the rally is in the past. In the fixed income space, the rally in the Eurozone periphery (Greece, Portugal, Italy) is clearly over. Corporate credit in euros will likely struggle as credit spreads widen to take account of the deteriorating economy. The yield on Bunds is tiny, which leaves dollar-denominated fixed income – EM Bonds or Treasuries. All you need to believe is that the euro will continue to depreciate against the dollar.

A fall in the euro / dollar exchange rate is just about the most consensus call in global economics, but that doesn’t necessarily mean that it’s wrong. If the ECB goes ahead with QE-lite, the most likely result is a weaker euro. If not, the slowdown in the Eurozone economy will probably achieve the same result. All of which leaves Treasuries looking like a good each-way be for Eurozone investors. For the year to date, the Eurozone is running a current account surplus of €18bn a month. If they decide that their best investment is US Treasuries, Eurozone investors have more than enough firepower to push Treasury yields well below the level justified by the performance of the US economy. Compared with Bunds, they get a yield pick-up of 100bps in the middle of the curve and the chance of 10% currency gain or more. This could be the start of a very big carry trade.

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