Peter's Perspective
20th October 2014 by Peter Churchouse

A Correction Doesn’t Concern Me, But This Does…

I just wanted to touch base quickly as I’ve received a few pretty panicky questions and comments from some of our readers.

As you all know, the markets are taking a bit of a pounding right now.

The Dow Jones Industrial Average and S&P 500 are down nearly over 5% in a little over a week.

The Euro Stoxx 100 down nearly 10% since the start of the month.

And Asia isn’t doing all that much better, especially Japan’s Nikkei down nearly double digits since early October.

Volatility as measured by the VIX Index (the “fear gauge”) has spiked from 15 to 25, the highest since mid-2012.

In my mind, thus far this is a pretty healthy correction. There’s no need for fear or panic right now.

What does concern me however, are sovereign bond markets. And in particular European sovereign bonds.

If bond prices are about risks, it would appear that investors see virtually no risk of default in any of the major Eurozone countries.

I’d like you to take a look at the chart below. The bars show the current yields for benchmark 10 year bonds for a range of European (in green) and Global (in blue) governments.

The yellow dot shows the lowest yield traded for that country over the past 12 months.

The red dot shows the high yield over the past 12 months.

*Remember, when yields come down, prices go up and vice versa.

The first thing that that should be apparent is just how much yields have come down from their 12 month highs.

Nearly every single major global economy is trading at one year lows in terms of yields.

Select 10 Year Sovereign Bond Yields Oct 2014 for Switzerland, Japan, Germany, Netherlands, Austria, Denmark, Belgium, France, Sweden, Ireland, Canada, U.K., U.S., Spain, Italy, Korea, Australia, Portugal, Brazil, and New Zealand.

This means bond prices right now are very high.

The second thing that strikes me is just how much European bond yields in particular have come down.

(Note: The exception is Greece, where bond prices are quite literally in freefall with the 10 year yield going from 6.6% to nearly 9% in a matter of days. Price-wise, this is a drop from roughly 78 cents on the euro, to 66 cents… or 15.5%).

But everywhere else in Europe, these prices in my opinion are simply insane.

Bond markets are pricing in a Japan-style lost decade of no growth and zero inflation or deflation.

  • Spain is trading at the same yield as the U.S.!
  • Lending money to the French government for 10 years will earn you all of 1 percent per year!

And the insanity doesn’t end there by any means. Look at where 2 year yields are currently priced (Figure 2 below).

Most European bonds in the 2 year space currently have NEGATIVE yields.

This means you are PAYING the government money just to hold their bond…. After you buy the bond and receive the coupon and the redemption at maturity, you end up with less money than you started. Madness.

2 Year Sovereign Bond Yields (Oct 2014) for Switzerland, Japan, Germany, Netherlands, Austria, Denmark, Belgium, France, Sweden, Ireland, Canada, U.K., U.S., Spain, Italy, Korea, Australia, Portugal, Brazil, and New Zealand.

It was not too long ago that the markets were sweating default risk in Greece, Portugal, and Spain. Investors even muttered about France’s long term solvency. Bonds of these countries were dumped by investors pushing yields to record high levels.

Greek bonds peaked out at a yield of nearly 37%. For Portugal the yield peaked at just over 16%, and Spain, topped out at just over 6% (in the most recent financial crisis).

Well, the market seems to think that there is virtually no default risk in these markets these days. Today the yield on Portuguese government bonds is a mere 115 basis points (or 1.15%) higher than US bonds. And for Spain, bonds are priced the same as US bonds!

Given the mess that Europe is in, do we really believe that default risk for these troubled countries is zero? I for one do not.

Clearly default risk has vacated the minds of bond investors in Europe. So what is driving them to pay hugely more for Euro zone bonds than they were prepared to pay a year and two years ago?

Well, there are a few things….

The first is shown clearly in this next chart. This is the one I think keeps Mario Draghi up at night. And it’s one of the reasons why we are witnessing an almighty bubble in European sovereign bonds.

It’s inflation. Well, the lack of it. Deflation has now taken hold in both Italy and Spain, and seemingly France and Germany are headed in the same direction.

European Harmonised Year on Year CPI from Jan 2008 - Oct 2014

If inflation is the enemy of fixed income securities, then deflation is its friend. However, deflation is terrible for everything else.

Why? Because when prices fall consumers and companies become less willing to spend and less willing to invest and borrow. Why buy something now when I can buy it for less later?

It starts to make sense simply to keep hold of cash as that will at least give you some kind of real return, even if it pays no interest! If I put $100 in the bank, and earn 0% interest with -1% inflation, then my $100 is actually worth $101 in spending power a year from today.

Borrowing for companies becomes increasingly worrisome for both companies and governments because those loans will be repaid with money that is more expensive than when you borrowed. Along with the fact that wages stagnate or fall…. Well, you start to get the picture that zero or negative inflation is not supportive of economic growth.

The second reason why yields are falling is that investors are betting that the European Central Bank (ECB) will engage in measures to keep interest rates low for “an extended period”- to coin what is now a central bank cliche.

The market is betting that Mario Draghi, the ECB’s head, will be forced to indulge in the US vice of quantitative easing. It will go out into the market and buy bonds from banks (and other financial institutions) in an effort to encourage banks to lend more to consumers and companies. That is supposed to kick start the local economies of Europe and bring inflation back towards the ECB’s two percent target.

In other words, the ECB is tipped to take a chapter out the US Federal Reserve’s script. Europe is shaping up to follow down the US path of financial and economic recovery. It is just several years behind the US in getting this particular act together.

The US is now the textbook case study for Europe’s own recovery process. Investors have seen how long it took for the US financial and economic recovery to take place. Interest rates have stayed low for much longer in the US than investors originally expected.

We are already six years into zero rates in the U.S. Growth has taken a long time to re-ignite. Unemployment was slow to recede, and even now there are still concerns about large numbers of people who have left the workforce.

Consumer spending has been slow to rebound, and household incomes are still down in real terms.

Consumer spending cannot accelerate if incomes are in stall mode.

Europe’s financial and economic prospects are even more dire than that of the US a few years ago. This is especially concerning due to the differing political and economic views held by the likes of Germany and France. Investors therefore seem to be saying that, given the US experience, low interest rates will persist in Europe for even longer than they have in the US.

The Euro zone’s decision making paralysis gives investors good reason to believe that recovery will be a slow, painful, drawn out process. Hence the investor thinking that holding government bonds is the way to go. Bond yields in the US went lower than people thought, i.e. bond prices went higher than predicted by most. That model is probably guiding investor thinking on European bonds.

The final reason is one I touched on in the previous paragraph. European economic prospects are currently looking grim. Greece’s plan to exit the IMF program and return to market ‘funding’ is in ruins. Political risk across the Euro spectrum is increasing. Much needed financial and public sector reforms are stalling. France is set to run a budget deficit some 1.5% over what the European Commission mandates (which is 3% of GDP).

Investors piling into European debt may be right. Yields can always go lower. But right now I would be very worried about having any meaningful sized exposure to European government bonds at these levels. Default risk is likely to come up on the radar again.

I do not believe that the ECB can backstop the entire European sovereign bond market.

I’d rather hold cash, and be on the lookout for opportunities in european equities if we see a substantial round of monetary easing.

And as I mentioned in our last report to subscribers, we have yet to stop out on any of our current 28 open positions although we are close on a couple. I strongly advise people to be mindful of their stop loss levels in the current environment. This global pullback will also likely present us with some good opportunities to buy great names at good prices.

Good investing,


P.S. We are roughly 10 days away from the launch of our brand new and much improved publication platform. I am very much looking forward to sharing it with you.

P.P.S. If you want more specific investment recommendations, try our 50 day risk-free trial of The Churchouse Letter.

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