Gently Sloping Summer
A degree of irony exists in the fact that just as rating agencies are questioning the solvency levels of sovereign states and hence, the quality of their balance sheets, investors are rushing to buy the debts of these same states at increasingly high prices.
This trend has been noted with both individual and institutional investors, and even at central banks. Over the summer, the Bank of China stepped up purchases of Japanese bonds, which already totalled $20bn in H1 this year. Bearing in mind that these bonds yield just 1% a year at best, we could conclude that either the Chinese state is not particularly demanding in terms of its yield requirements or it is extremely optimistic on a future appreciation of the yen! While the example of Japanese debt is striking, all major bond markets are concerned and bond purchases have pushed down both US and German rates. Our gentle slope is therefore that of long-term rates, which in Germany for example, have dropped from 3.3% at the start of the year to 2.6% at the end of June before waning further to 2.1% at this end of the summer.
How can we explain the appeal for such an unprofitable asset? Actually, the situation is not new and a look back at the 1930s after the great depression shows that the decline in US long-term rates lasted for 15 years. The trend was a direct consequence of debt reduction by US households. While history is repeating itself now, two other explanations can be added. The first is psychological, with the fear of investing in assets that are considered risky, while the second is economic, with the fear of a long period of deflation.
Although fear is often a bad advisor, the first explanation is above all contestable since the status of government bonds is indeed far more a status of low risk than a status of zero risk. So why allow ourselves to be tempted by an anaemic remuneration level? Because deflationary risk is genuine, answer the bond buyers. The Japanese example provides a perfect illustration. After 20 years of falling asset prices, investors are no longer seeking high returns but would rather keep their savings intact and this justifies in sort the 1% return mentioned above. Preserving capital has become more important than generating the profitability hoped for.
We do not believe in the deflationary scenario mentioned above either. Low growth in a number of regions is possible and even highly likely but a “world in deflation”, looks very improbable given that growth in Brazil is set to total 5% and China 10%. Traction by emerging markets is gradually taking over from that provided by the US in terms of global growth.
In addition, industrialists are not wrong. Far from acquiring government bonds, they are buying other companies: BHP BILLITON is trying to acquire POTASH CORP for $39bn, INTEL is buying MC AFEE for $7.7bn and INFINEON’s mobile chips for $1.4bn, while RECKITT BENCKISER has acquired SSL for $1.8bn.
During August, these acquisitions operations represented $240bn, thereby confirming an acceleration in the trend started in July. Premiums and multiples paid are therefore not those of a world in deflation, but those of a world in transformation.
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