EU Economy
Global investors fear bond/ share bubbles as Faust stalks euro debtors' paradise
By Michael Hennigan, Finfacts founder and editor
Apr 15, 2015 - 7:36 AM

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Global investors see growing overvaluations in both bonds and equities and have signaled concern about a valuation bubble forming, according to the BofA Merrill Lynch Fund Manager Survey for April. With an estimated €1.5tn of euro sovereign bonds now showing negative yields, the Eurozone is increasingly seen as a debtors’ paradise. According to the FT more than two-thirds of euro denominated corporate bonds rated as investment grade now yield less than 1% as borrowing costs continue to tumble following the launch of quantitative easing in the Eurozone.

The proportion of global investors saying equity markets are overvalued has reached its highest level since 2000. A net 25% of respondents to the global survey say that global equities are currently overvalued, up from a net 23% in March and a net 8% in February. This is still, however, short of the record-high level of a net 42% in 1999.

At the same time, the proportion of respondents saying that bond markets are overvalued has reached a new high in the survey’s history dating from 1998. A net 84% of the global panel says that bonds are overvalued, up from a net 75% in March. At the same time, 13% believe that “equity bubbles” are the biggest tail risk markets are facing, up from 2% in February.

Global respondents believe that the focus of overvaluation is on the US — a net 68% of the panel says that the US is the most overvalued region globally. Global panelists believe that all other regions, including Europe and Japan remain undervalued.

These assessments come as investors increasingly accept that US rates will rise at a time when the European Central Bank and the Bank of Japan are engaged in monetary stimulus. Although a majority of investors expect no Fed hike before the third quarter, 85% expect a rate rise to take place this year.

“April’s survey offers further proof that global investors are front-running global monetary policy," said Michael Hartnett, chief investment strategist at BofA Merrill Lynch Research. “We are seeing a form of rational exuberance in Europe where a positive view on stocks is supported by fundamentals – but investors no longer believe valuations are cheap," said Manish Kabra, European equity and quantitative strategist.

The FT reports today the largest quarterly flow into global bond-exposed exchange traded funds during the first three months of the year. Some $37.6bn poured into fixed income, the second successive record breaking quarter, according to Markit.

Faust

In 2012, the 180th anniversary of the death of Johann Wolfgang von Goethe (1749-1832), the renowned German writer, Faust, his most famous creation, was deployed against modern-day money printing, known as quantitative easing, in his hometown of Frankfurt, host to two central banks in modern times — the Deutsche Bundesbank and the European Central Bank.

In July of that year, Mario Draghi, ECB president, had made a hugely significant commitment at an event in London: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

In September 2012 the ECB's governing council agreed to an Outright Monetary Transactions (OMT) bond-buying program that would be triggered if Draghi's commitment was to be actioned. In response, Jens Weidmann, Bundesbank president, said that efforts by central banks to pump money into the economy reminded him of the scene in Faust when the devil Mephistopheles, “disguised as a fool,” convinces an indebted Holy Roman Emperor to issue large amounts of paper money.

In Goethe’s classic, the money printing solves the kingdom’s financial problems but the tale ends badly with rampant inflation. Without mentioning Mario Draghi’s bond-buying programme, Dr Weidmann said: “If a central bank can potentially create unlimited money from nothing, how can it ensure that money is sufficiently scarce to retain its value?” He added: “Yes, this temptation certainly exists, and many in monetary history have succumbed to it.”

Rampant inflation is an irrational fear in 2015 but on Tuesday, John Plender, FT columnist highlighted that quantitative easing (QE) in the Eurozone is different to the US and UK programs. He says on the Eurozone program: "The hallmark is the advance of negative interest rates and negative bond yields across the continent."

Plender wrote that the "Eurozone looks increasingly like a debtors’ paradise...Creditors are the losers, though with at least one big exception: members of defined benefit pension schemes."

Negative bond yields create pension fund deficits; almost cost-free corporate debt can distort capital allocation and investors may wonder about the quality of earnings boosted by a soft euro and falling debt costs. Meanwhile falling public debt servicing can prompt politicians to raise public spending based on temporary windfalls.

John Plender concludes:

It will take quite a while for the negative yield phenomenon to go away, but go away it will. And when it does, those who thought it a good idea to rethink conventional definitions of solvency may have a nasty surprise."

The earnings season for the first quarter is underway, following dramatic writedowns in earnings forecasts. Ian Harnett, managing director at Absolute Strategy Research tells FT's John Authers why US earnings will be worse than the writedowns.


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