By Nick Gartside, portfolio manager of JPMorgan Funds – Global Bond Opportunities fund
Mention Japan to an economist and they’ll tell you about deflation, debt crises, demographic pressures and decades lost in economic stagnation. In fact, the ingredients of every policymaker’s nightmare scenario and the situation eurozone monetary authorities are desperate to avoid.
You don’t need to scratch under the surface though to see that there are some uncanny parallels between events in Japan over the last decade or so and the current situation in the eurozone which faces a poor demographic outlook, sluggish economic growth and prospective deflation.
Indeed, under certain indicators the eurozone looks a little worse than Japan with around one quarter of all eurozone government bonds now with a negative yield versus none in Japan. This is further exacerbated by a political polity that has reacted slowly to the unfolding debt and deflation crisis. With Japanification prominently in evidence in the bond markets, it is reasonable for investors to question whether Europe may in fact succumb to Japan’s legacy of moribund growth and persistent deflation.
Arguably, however, there is light at the end of the tunnel and perhaps eurozone policy makers have learned from the Japanese experience. Institutionally speaking, Europe is a much better place to be an investor than it was a few years ago. Essentially there are three interrelated issues in the Eurozone that resemble a wobbly, three legged stool: bank fragility, sovereign stress and weak public finances. The first two of these problems have been dealt with by the European Central Bank.
Initially, the Long Term Re-financing Operations (LTROs) provided liquidity to banks subsequently improving their capital positions and solvency ratios. Likewise, the ECB proposal of Outright Monetary Transactions (OMT) provided a safety net to government bond markets and drove yields down from around 7% for Italian and Spanish 10 yr notes to around 1.5% today. The remaining hurdle for the eurozone remains much needed structural reforms and the reform of public finances – as such we should expect the theme of anti-austerity to remain a flashpoint as the electoral cycle unfolds over coming years.
With two legs of the stool now stable though, the eurozone is much better to withstand future shocks. Critically, the Japanese experience also presents an interesting road map for bond investors. Just because yields are low, doesn’t mean they are unable to go even lower, delivering returns. Japanese government bonds in 2014, for example, returned close to 5% with the 10 year yield starting the year at just 73bp. Whilst it may be early to read the tea leaves for Europe, Japan offers a cautionary tale when it comes to betting against low yields.
For more than a decade, bears who bet against Japan’s bonds, believing that the government’s debts would eventually overwhelm it, have been disappointed; yields have stayed very low and Japanese bonds have been the graveyard for global fixed income managers. The trade has been so destructive of wealth that it has become known as the “widowmaker”.
Contrast that with where we currently see value in Europe. Spanish and Italy sovereign bonds look attractive; we think they could go as much as 50 basis points lower in spread than current levels. When the ECB actually starts buying bonds in March as part of the QE programme, this will create a net negative supply – a powerful alteration of the supply and demand dynamic.
The grab for yield will also extend to the corporate sectors, both investment grade and high yield, where fundamentals will be underpinned by a supportive central bank, an improving economy, a boost from the weakening currency and falling oil prices. With the yield on German government bonds negative out to six years investors can expect to clip coupons and also generate some capital gains.
The other message from Europe, with a backdrop of negative yields, is not only what bonds investors should be buying but how to invest in fixed income markets with the growing percentage of negatively yielding bonds. That leaves traditional fixed income total return prospects modest in the best case, and more likely negative.
Increasingly, investors are shunning traditional, benchmark aware strategies and embracing strategies that are benchmark unaware with an ability to allocate capital to those markets which offer value, as opposed to just a large index weight. These strategies open the door to a more diverse set of global opportunities in order to drive returns.
So, in our view the lessons learned for bond investors in today’s environment are:
- Don’t underestimate central banks and don’t fight the ECB – they can still surprise us and they are powerful buyers
- Even at these yield levels, fixed income retains its capacity to surprise and to deliver returns. Peripheral governments such as Spain and Italy offer value as well as investment grade and high yield corporate sectors
- Beware benchmarks in an environment of negative yields and look for strategies that allocate capital on a flexible, unconstrained and benchmark unaware approach.