Review & Outlook

Our take on the investing, financial, & economic themes of the day

The Bizarro Market in Europe

1 June, 2017 by Mark O'Brien in Commentary

The chart below is amazing.  It originates from Bank of America’s Merrill Lynch and shows the yield of European stocks currently exceeding the yield of European junk bonds.

So why do I think this state of affairs is “amazing?”  First there is one’s reaction or reactions.  In my case, at first blush, I wanted to run out and buy European stocks in order to collect the appreciation potential of stocks along with all the high current income of junk bonds.  It would appear to be the best of all possible worlds.  That was my first reaction.  My second reaction,  which emerged  upon further reflection, was one of alarm.

Several years ago we had something similar here in the U.S., when American stocks yielded more than government bonds.  I had never seen anything like that, either.  But this European situation is even more extreme. Junk bonds are not government bonds.  They are called junk for a reason.   And so “normally” they have to pay a huge yield premium to compensate investors for their inherent risk.  But now European junk bonds have tiny yields, even lower than those of common stock dividends.  To express it differently, in order to have such low yields, European junk bonds have to have  sky-high prices.  That is the way the bond yield/bond price dynamic works: low yields translate into high prices and vice versa.  I don’t want to get lost in an explanation of how bonds work.  For purposes of discussion here, it is enough to say that financial assets are out of whack in Europe.

It is one thing for central banks to prop up government bonds (that’s been going on for a long time), quite another for them to prop up the junk bond market.  And it is this course that the European Central Bank appears to have take. Two really big questions stand out.  First, how long can this buying go on?   Second, what happens when the central banks reverse course?  No one knows the exact answers to these questions, but it is save to safe this policy is high risk.

European Central Bank policy has many moving parts, though all are related to the lowest interest rates in 400 years.  In subsequent posts I’ll comment on a few of the consequences, intended and unintended, as I see them.