Wednesday, June 10th, 2015

Small Chart: Big Message

Tucked away in the middle of our Euro asset allocation pack is a chart which compares the risk-adjusted returns of medium-dated German Bunds with US Treasuries translated into euros. It is designed to help European investors get a handle on the interaction between currency and interest rate risk in the main developed-government bond markets. Given the rise in German bund yields, one might expect it to show a clear preference for US Treasuries – and it does, in the sense that we have an overweight recommendation. But our recommended overweight is much smaller than it was a month ago and the shape of probability curve suggests that it will be cut to neutral in the next few weeks. The message is that the rise in German yields is driven by US yields and is not an isolated event caused by the ECB, or a change in view about the European economy.

Some commentators have suggested that rising yields are the precursor of a general flight from fixed income in Europe, including investment grade corporate debt and/or euro-denominated emerging market bonds. Even if bond yields are about to start the long march back towards “the old-normal”, certain truths will still be relevant. First this process cannot decouple from the US for any length of time. Second, the impact of exchange rates will always offer international bond investors the opportunity to boost returns by hedging the interest rate risk and keeping the currency risk (or vice-versa). Third, if yields rise because the economy is recovering, it will be perfectly sensible to reduce duration and take more credit risk, especially if – as in the case of Europe – the amount of investment grade issuance is falling. Fourth, whatever happens to the previous three rules, there is a huge amount of capital which will remain trapped in fixed income markets because of regulatory or actuarial reasons.

We also believe that the rise in bond yields is not enough on its own prompt an immediate sell-off in European equities. The European equity markets face many challenges, but an excessively low yield gap is not one of them. Many institutional investors in Europe have lower benchmark equity weights than they did ten years ago and the rise in bond yields will not prompt them to reduce that benchmark further. They may, however, decide to reduce the potential exposure to rising domestic bond yields by increasing the weight of international equities, particularly outside the US. For many months we have argued that Japan offers a low-risk way of diversifying away from the interest rate sensitivity of US and European equity markets and that it has a much better narrative than for the last twenty-five years. We also note that the weighting of China in global and emerging-market benchmarks is scheduled to increase over the next two years and that this will lead to a type of forced diversification. This may well end badly in a few years’ time, but institutional investors will find it very difficult not to make a start.

Diversification of equity portfolios is by definition a medium-term story, which is hard to identify in our charts, but we can at least observe what they say about rotation within the fixed income universe. In European we see a clear move out of government bonds (German and US) and into investment grade and emerging market debt. In the US we see the same trade, but with high yield as the prime beneficiary.

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