European Central Bank chief Mario Draghi said last week he saw no bubbles in European asset prices, only a day after Deutsche Bank chief executive John Cryan insisted there were “signs of bubbles” building in the region’s capital markets.
Who’s right? A glance across Europe’s markets suggests some froth forming in certain corners at least.
After years of volatility surrounding the global banking crash and subsequent euro debt crisis, the European Central Bank’s remedy was to flood the bloc with cheap cash and directly support lending and bond markets via massive asset purchases.
The euro zone economy has finally responded this year and is currently enjoying its best run since the single currency’s 1999 launch — even if inflation remains subdued and below ECB targets. Europe’s asset markets have responded. Equity, credit and real estate prices have accelerated, challenging the ECB to withdraw its ultra-loose monetary policy before unsustainable bubbles develop.
European high yield markets are trading significantly above their long-term historical valuation ranges, as this chart shows.
The ECB’s 2.3 trillion euro (£2.07 trillion) bond-buying stimulus has driven borrowing costs in the single currency bloc to record lows.
While stronger economic growth and an expectation that the scheme will be scaled back in coming months have pushed bond yields higher over the past year, a large chunk of the market remains in negative territory.
According to JPMorgan Asset Management, 36 percent of government bond yields in the euro zone are below zero, compared with a peak in June 2016 of 51 percent.
This chart shows which euro zone bonds are trading below the region’s inflation.
For bond strategists, another example of how the ECB’s quantitative easing programme has inflated government bond prices in the bloc is to compare Italian bonds against U.S. Treasuries.
Ten-year bond yields in Italy, a lower-rated sovereign that is often viewed as one of the weakest links in the euro area, have traded below U.S. Treasury yields for almost the entire period since the ECB signalled in late 2014 that it would start buying bonds to boost inflation and growth.
See chart below.
“It’s hard to say there isn’t some kind of over-inflated asset prices,” said Iain Stealey, senior fixed income manager at JPMorgan Asset Management.
“You’ve got negatively-yielding government bonds in an economy that is growing at a nominal growth rate approaching 4 percent. So there is a disconnect.”
The euro’s 14 percent surge against the dollar this year, its biggest annual rise since 2004, has turned around market expectations, and euro/dollar is the most crowded trade in the currency markets.
Figures from the U.S. Commodity Futures Trading Commission (CFTC) show that hedge funds and other speculators now hold the biggest net long euro position since May 2011.
Morgan Stanley’s own surveys show 93 percent of currency traders are bullish on the euro against the dollar, but some market watchers saying that kind of positioning is unlikely to be sustained for long.
“We think the euro has gone too far in too short a period and that should remain a worry for policymakers,” said Richard Falkenhall, a senior currency strategist at SEB.
A concern for some is that the euro’s steep appreciation has drawn in non-euro zone investors to the zone’s assets and flattered both the inflows and the returns in debt and equity. Any sudden currency reversal could have ripple effects across euro markets as result, even if economists would ultimately see that as a boon for growth.
Perhaps the area where investors are most divided on whether bubbles exist in the euro zone is in equities, where the MSCI Europe equity index is still more than 20 percent below its pre-2008 highs and valuations are broadly in line with long term averages.
That is sharply in contrast to U.S. equities, which are overvalued across a range of key metrics. At the same time, expectations in Europe have grown considerably, with earnings growth forecast to expand in double digits in the coming months, according to Ken Hsia, a portfolio manager at Investec European Equity Fund who manages over $2 billion (£1.51 billion).
But Hsia notes that bond proxy bets such as consumer durables are among the most expensive parts of the stock markets with a lot of positive earnings expectations already priced in.
Source: Reuters (Reporting by Dhara Ranasinghe, Saikat Chatterjee and Vikram Subhedar; Editing by Mike Dolan and Mark Trevelyan)