Since the great financial crisis roughly 10 years ago, investors are conditioned to expect the unexpected, but as long-term value investors, we at Western Asset still firmly believe that ultimately, macroeconomic fundamentals prevail and are the key determinant of valuations. So while it is possible that bund yields will grind even lower, our view is that they reflect too much bad news and remain detached from the key long-term macro drivers.
In our opinion there is a confluence of factors—several of which are not directly linked to domestic fundamentals—that has led to German bunds becoming a lightning rod for market anxiety. These include (but are not limited to):
- Escalated global trade tensions (eurozone countries have a high degree of trade openness)
- The strong rally in US Treasury yields (>100 bps from the recent November 2018 peak)
- Increased “no-deal” Brexit fears
- Renewed focus on Italian debt and fiscal dynamics
- Unresponsive inflation expectations
After a very weak 2H18, growth in both Germany and in the broader eurozone has improved and come in above market expectations as the negative impact of industry-specific factors, in particular those affecting the auto sector, have started to fade. Forward-looking survey data have improved and rebounded from the low point in January. The domestic drivers of growth in the majority of eurozone countries, including Germany, remain robust and thus far have proven to be resilient to protracted weakness in the manufacturing sector. The labor market in particular remains solid with good income growth supporting private consumption. Incorporating both hard data and forward-looking indicators, we expect eurozone growth to be around 1% this year—not spectacular but only slightly below estimates of the region’s potential annual growth rate of 1.3%, and sufficiently strong that we feel recession fears are significantly overdone. Importantly, the European Central Bank has stated it’s committed to providing policy accommodation to support the recovery and remains willing to act if material downside growth risks emerge.
Western Asset’s View
While we remain attentive to external headwinds, in particular to the potential escalation of global trade tensions, we believe investors are too pessimistic about the outlook for both eurozone and global growth. Absent a significant worsening of trade tensions and/or a sharp deceleration in US and China activity in 2H19, we believe the overall level of global developed market bond yields reflects too much pessimism, and within this universe, German bunds are the most overvalued.
German bund yields were above 0.5% as recently as October of last year, a period when the German economy was contracting. If our base case of “sturdy but unspectacular” global growth proves correct, we believe that bund yields should once again return to positive-yielding territory of at least year-end 2018 levels of 0.2%.