ECB government bond demand can push yields further south and bond holders can keep riding the wave of portfolio gains. Yet, once bond yields stabilize and total return expectations get ever smaller or negative, investors will likely start reallocating their money.

German bond yields: how low can they go?

As bond yields head further south, the search for yield intensifies
Source: Thomson Reuters Datastream, NN IP (01/01/2013 – 17/04/2015)

Strong undercurrent of support for global markets

The modest, yet sustainable global economic recovery has lost some momentum in the first quarter and therefore easy monetary policy remains in place. This situation is benign for global markets. Rising GDP and earnings levels and healing labour markets are more broad-based than ever since the Great Financial Crisis (GFC). Seemingly structurally impaired regions, like the Eurozone and Japan, are showing signs of life and liquidity is ample. These observations help explain the undercurrent of support for markets.

Some parts of the market should be treated with caution

Nevertheless, the damage done by the GFC teaches us all how dangerous financial instability can be. Any hint of it should therefore be treated with caution, even if flagged by a suspicious bunch. It seems difficult to argue that global markets as a whole or in one specific region are already really in a bubble, but some specific pockets in some specific countries are starting to look tricky. The local Chinese equity market is one example and the German Bund market also looks increasingly overextended.

Little fundamental justification for Chinese rally

The stock market rally in China explains most of the outperformance of emerging market equities since mid-March. The rally is driven mainly by technical factors. Chinese retail investors are borrowing to buy equities. The government likes the rally, because it needs a strong capital market if it wants to clean up the banking system at some point. This perhaps means that the momentum trade can continue. But foreigners have been selling the market recently, and it remains difficult to find fundamental justification for the rally. The Chinese economy is still slowing, while leverage growth continues to increase. Meanwhile, capital is flowing out, which reduces the effectiveness of monetary easing.

Short-term reversal in German Bund market seems unlikely

For international investors the German bond market is most relevant, although the fallout from a sharp correction in China should also not be ignored. Due to the expected persistence in key drivers of the rally in German Bunds (low inflation, regulatory incentives for institutional investors and the ECB’s QE program) it seems unlikely to expect a quick reversal. Also, low inflation and easy ECB policy are actually a reflection of the very unusual macroeconomic backdrop in Europe, implying that a big part of the low-yield environment is not a bubbly mismatch between markets and underlying fundamentals.

We increased our underweight in Bunds

At the same time, it is fair to state that we have reached extreme levels in the German Bund market with 10-year yields trading below 10 basis points. Demand for government bonds from the ECB can push yields further south and existing government bond holders can keep riding the wave of portfolio gains. Yet, once bond yields stabilize and total return expectations get ever smaller or negative, investors are likely to start reallocating their money.

Observing these developments, we decided to further adapt our asset allocation stance and moved (German) government bonds to a strong underweight. Not because we necessarily expect to reverse course very quickly, but mainly because even stable or further rallying markets have very little additional upside to offer, while a potential sell-off carries significant drawdown risk.

Upgrade real estate to a strong overweight

We made two other allocation changes, as we upgraded real estate to a strong overweight, while downgrading fixed income spread products to a neutral stance. Both asset classes are candidates to profit from the continuous search for yield, yet fundamental and behavioural trends are much more favourable for real estate at this point.