Are we seeing the Japanification of Europe?
A rather important event happened a few days ago. While the benchmark German bond yield fell below the equivalent yield in Japan for the third time in recent history, it has now exceeded the record number of days with the yield spread negative – 40 days and counting. Up until April 2015, this had never happened before. Indeed, the average spread before this date exceeded 2.3%; now, like negative yielding debt itself, it is becoming a ‘normal’ occurrence.
What does such an event tell us? In one sense, the bond markets are behaving very logically. There is a slowdown in the European economy and the central bank is responding. Mario Draghi, the president of the European Central Bank (ECB), announced a few weeks ago that policymakers anticipate using an interest rate cut as their first move, while leaving the door open to a revival of the quantitative easing (QE) programme. Bond purchases could cover both government and corporate debt. Yields collapsed as a result. German 10-year bond yields started the year around 0.3%, and have fallen towards -0.4%. Indeed, the German bond curve is now negative out to 20-years maturity.
The European Central Bank is not only responding to economic weakness but a failure of monetary policy.
We must dig deeper, however. The ECB is not only responding to economic weakness but a failure of monetary policy. Its target is inflation “below, but close to, 2%” over the medium term. Bond markets are currently anticipating that inflation will be closer to 1.2% over the next five years. Not all of this can be blamed on short-term issues, such as the trade war between the US and China or the major problems facing the European automobile industry. Many observers are asking whether Europe is following the same path as Japan.
At first sight, the parallels are indeed worrying: weak economic growth, demographic headwinds from an ageing population, very low inflation expectations, and a mass of negative-yielding debt. There are differences, however – some to Europe’s benefit but some to Japan’s.
European banking woes
One example would be the state of the banking system in Europe. Although European equities have performed well this year on the back of the expected central bank stimulus, the banking sector has noticeably underperformed. While household credit demand remains positive, notably in relation to housing markets, the funding backdrop and net interest margins for the banks are poor in a world of flat or even negative yield curves. For too long, European banks have not dealt with non-performing loans. This comes against a picture of weak profitability and sizeable increases in the capital levels demanded by regulators. Hence the comprehensive cost-cutting programmes announced by such banks as Deutsche or Societe Generale.
Another similarity is the sensitivity to overseas developments. A global trade downturn and the rising threat of protectionism by major trading partners in the US and China are unhelpful to both Europe and Japan.
Yet there are differences too. Just because the Japanification process seen in many countries brings with it a flat or flatter yield curve, it need not be the case that a country with a flat yield curve will necessarily resemble Japan. For example, the demographics for a few European countries, such as Portugal, Greece and some of the Baltic states, do match those for Japan. That said, immigration into Europe is much more positive than for Japan. Japan is also taking steps to raise its productivity growth; as unemployment has fallen towards 2.5% in Japan, there have been efforts to encourage people to retire later. Eurozone unemployment is as high as 8%.
A second dissimilarity is the lack of a bubble and bust in Europe, which plagued Japan in the 1980s and 1990s. The private sector in Europe has a sizeable surplus, the balance sheets of most companies are in decent shape, and there has not – yet – been a period of over-building in commercial or residential real estate. Some amber warning lights are flashing in Germany, however, sparked by record low borrowing costs.
A third difference is the political risks. It was good news that the European Commission decided not to proceed with a legal case against Italy’s budgetary position. Nonetheless, this issue could still flare up in coming months. Meanwhile, Brexit worries remain, and the fractured state of the European Parliament after the recent elections suggests limited scope for structural reforms. Populism is alive and well in Europe. This helps explain why sentiment towards European equities remains depressed and fund flows have been negative since last summer.
Finally, there is the policy structure in the two areas. It is clear the Bank of Japan is strongly influenced by signals from the Ministry of Finance. An example is in relation to the possible increase in the sales tax and any supplementary budget later this year. In Europe, the appointment of Christine Lagarde as ECB president may allow greater policy coordination. At present, a major problem for the Eurozone is fiscal, monetary and regulatory policies are carried out by very different groups in the currency bloc. In a crisis, Europe will be late to respond.
Who to choose?
Should investors prefer Japan or Europe in their portfolios? The answer is both, by buying different assets. European stock markets have done well in the past three months, led by tech and international consumer stocks. However, investors need to be selective. The number of zombie companies in Europe, defined as those with low interest cover, is on the rise. Our preference now is for Japanese equities over European equivalents. Future trends for company profits look little different in a world of low growth. Political risks are more of a concern in Europe than Japan. We are more impressed by the corporate governance changes in Japan and what they mean for the return of capital to shareholders. In terms of fixed income, we prefer European debt, especially high yield corporate bonds. All the signs are that the interest rate structure in Europe will remain lower for longer, especially if the ECB introduces a new QE programme. European real estate also remains attractive against this backdrop, as long as the ECB can ensure at least moderate growth and prevent recession.