Asian investors are still reluctant to put money to work in southern European debt but evidence is emerging, market insiders say, that some institutions are investing again in higher-rated eurozone sovereign bonds. However, with eurozone tensions still bubbling away beneath the surface, yield pickings few, and the European Central Bank under increased pressure to ease back on market support, that trickle of Asian interest is unlikely to become a flood any time soon.
Judging by the balance of payments data and anecdotal evidence from a recent trip to Japan, institutional investors there are starting to re-engage with continental European bond markets, said David Owen, chief European financial economist at Jefferies Investment Bank in London.
In particular, they are trading the yield differential between French and Dutch government bonds and German bunds, he told AsianInvestor. These spreads have narrowed sharply in recent months as the political risks have faded, especially in France with the election as president of the centrist Emmanuel Macron and defeat of the anti-euro Marine Le Pen.
That contrasts with the Asian selling seen late last year, notably by Japanese life insurers and South Korean investors, when French government bonds were dumped to fund the purchase of US assets following Donald Trump’s election victory, Owen said.
It’s not just in France. Dutch elections in March passed without incident and polls in Germany point to another win for incumbent Angela Merkel in September, adding to a growing belief that the eurozone will hold firm after all, defying the worst post-Brexit vote prognoses.
“Politics is less of a worry as eurosceptic and far-right parties have lost ground in recent elections, particularly France and the Netherlands,” said Frank Lee, DBS Bank’s acting chief investment officer for North Asia in Hong Kong.
But political risks continue to dog southern Europe, giving Asian investors reason not to throw caution to the wind just yet. Aside from the convoluted Brexit question, a minority government in Spain faces an extra-legal independence challenge this autumn in Catalonia. The threat of fresh Spanish elections if the government falls also remains real, as in Italy, where elections are due no later than May 20, 2018, and where anti-euro sentiment is strong.
And regardless of when exactly these Italian elections are called, the contradictions within the eurozone haven’t entirely gone away and will continue to feed Asian investor aversion to many peripheral European bonds, say analysts.
“Everyone realises that Europe’s issues have not been resolved,” Marchel Alexandrovich, a European financial economist also at Jefferies, said, echoing Lee’s justification for DBS’s continuing neutral stance on European bond markets.
The French relief rally after the defeat of Le Pen has also now run its course, say asset managers. “There was a lot of risk priced into the market which has now disappeared,” said Sandor Steverink, head of Treasuries and inflation-linked debt at Dutch pension manager APG Asset Management.
Noting how the spread between French and German government bonds, around 30 basis points historically, reached 80bp at the start of the year before narrowing back to around 35bp, he said APG had started selling down its overweight position in French bonds and bond futures after Macron was elected.
Spreads in Europe are also being measured off an extremely low base, with some core eurozone yields in deep negative territory. “This is just too expensive,” Steverink said, referencing the minus 70bp offered on two-year German government bonds. “Anybody with common sense won’t invest there for the long-term: you are sure it’ll lose money.”
“While peripheral European government bonds do still offer some additional yield, the very low absolute level of core government bond yields and investment grade credit – in particular, for Germany – have caused many institutional investors to reduce or minimise their exposure to both peripheral and core bonds,” said Christine Farquhar, managing director of global investment research at Cambridge Associates. Investment grade yields, which are typically priced off German government yields, are all below a 1%, she noted.
There is an additional consideration too, the ECB and its quantitative easing programme, and the fact that has to come to an end at some point, removing a major structural bid from the market.
“They are running out of bonds to buy,” Steverink told AsianInvestor. So having already trimmed its bond-buying programme in April to €60 billion per month from €80 billion, the ECB will soon have to retrench further on its bond buying.
APG calculates that the ECB will have to taper its current rate of bond buying by the middle of 2018 and Steverink expects it to start as soon as the start of next year. But if it happens too quickly, he added, Italian bonds could be in the firing line, especially if the political outlook does not stabilise.
So far, the news concerning the timing and scale of any ECB tapering is encouraging, said John Woods, chief investment officer for Asia Pacific at Credit Suisse. Communications from the central bank following its last meeting on June 7 have revealed “a dovish bias with an inclination to maintain accommodative conditions for the next few months at the very least", he added.
That combined with the growing possibility that Italy’s elections may not happen until next year, makes the yield pickup on Italian bonds attractive in the short term, Woods said.
Whether the yield on offer is enough to tempt significant Asian interest is another matter.