We have spent a lot of time talking about the unintended consequences of accommodative global central banking policies. Skyrocketing pension liabilities and the numerous corresponding reach for yield/duration trades, which have resulted in several of their own off-shooting market bubbles (in fact we just wrote about how one of the bubbles is bursting just yesterday "P2P Meltdown Continues: LoanDepot's CDO Collapses Just 10 Months After Issuance"), is just one of the many unintended consequences.
But, as Deutsche Bank's European equity strategist, Sebastian Raedler, points out today, even if central banks wanted to steepen the yield curve they likely can't. Raedler disputes the common explanation that low bond yields are due to discretionary central bank policies and argues instead that the recent fall in bond yields has been due to sustained weak global growth. This suggests low bond yields are not principally due to discretionary central bank policies (which could be reversed at will), but to the weakened global growth picture, to which central banks have only responded by making policy more accommodative. Of course, if Raedler is correct, the question then becomes why continue with accommodative policies if they're not driving incremental economic growth but clearly creating detrimental asset bubbles?
Raedler argues that global bond yields have fallen with central banking target rates but both have really just followed slowing global economic growth.
And accomodative policies can't be removed because expectations for future growth continue to decline.
Meanwhile, DB points out that despite accommodative policies the US economy has now activated all 4 of their "recession warning indicators" a condition which has resulted in a recession every time it's occurred over the past 30 years with the exception of 1986.
But, of course, as we've noted many times, central banks are stuck with their accommodative policies because any efforts to unwind them would result in a simultaneous unwind of the equity bubble they've facilitated.
Central banks are running out of road. They would like to engineer higher nominal bond yields to protect bank profitability. However, without stronger growth and higher inflation expectations, the only way to do so (less QE, faster hikes) would also push up real bond yields. Given that the fall in real bond yields has been a key driver in boosting asset prices (pushing the European P/E 20% above its 10-year average and US HY credit spreads far below the level suggested by fundamentals), a rise in real bond yields would likely lead to a negative re-pricing of global risk assets. This would tighten financial conditions, further weaken growth and force central banks to ease policy again, leading to a renewed fall in nominal bond yields.
As Raedler points out, equities are more overvalued than at any other point since 1800 with the majority of the valuation premium explained by artificially low bond yields resulting in lower discount rates.
And, based on the thesis that Central Banks are stuck with their current policies, Raedler concludes that investors have no choice but to stick with the status quo of buying high dividend "bond proxies" and selling financials.
Remain cautious on equities: central banks’ willingness to underwrite low real bond yields has protected asset valuations even as global growth has slowed. Yet, with central banks unwilling to lower bond yields further (because of the impact on financial sector profitability), the upside from this factor is increasingly capped, while slower global growth means downside risk for equities. We maintain our Stoxx 600 year-end target of 325 (5% below current levels).
Remain overweight bond proxies: our basket of sustainable dividend payers and real estate should benefit if bond yields remain low due to the dynamics discussed above. Consumer staples should also benefit, though we’re concerned about the risk from EM FX exposure (40% of sales), with our FX strategists still seeing downside for the RMB.
Financials will likely continue to struggle if bond yields remain low. This should also been a problem for stocks with large pension deficits and Europe’s performance relative to global equities, which continues to track bond yields.
Which, of course, works until it doesn't.