Europe: bonds or equities?

European financial markets remain very volatile, with unusually strong swings in sentiment. Active investors, including hedge funds, are struggling to get a grip on these mood swings, which are mostly caused by political decision making, rather than corporate fundamentals. One of the most surprising characteristics of the current crisis is the fact that bond investors appear to discount more eurostress than equity investors. Is this justified?

This disparity in behaviour has caused some strange anomalies. Sovereign bond yields in the south of Europe rose to (over) 6% and yields in the northern countries fell to 2%. However, equity markets in the south did not perform worse this year than those in the north, with the exception of Greece, where equities plunged. Whilst this lack of discrimination by equity investors does make sense for truly international companies, where the country of “residence” is not so important, it does much less so for domestically oriented companies.

To give an example: A German or Dutch telecom company currently provides investors with a dividend yield which is four times higher than the German or Dutch bond yield. However, an Italian or Spanish telecom company pays a dividend yield which is only slightly higher than the sovereign bond yield of these countries. This is remarkable, even when one takes into account the fact that these latter companies also have activities in Latin America. The same north-south comparison can be made for utility companies and other domestic stocks, with a similar outcome. In other words, northern investors appear to receive a higher reward for taking on equity risk than southern ones, at least in comparison to their local sovereign bond yields.

Furthermore, investors have to realise that in the south the risk of increased taxation by cash hungry governments of cash rich companies is probably higher than in the north. After all, these governments are under growing pressure to balance their budgets and after two profitable years companies are generally in a better shape to serve as a source of funds than the population at large.

What is the lesson which investors can take from this?

Looking at Europe, one has to acknowledge that the eurozone can only survive when sovereign bond yields in countries like Italy and Spain remain at or below current levels. These countries can simply not deal with much higher levels for a prolonged period. Therefore, if one believes that the eurozone has a future, sovereign bonds of these countries are starting to look like an attractive investment, certainly relative to their own equity markets. Conversely, in the northern equity markets the relative case for equities is more compelling, assuming that we will only face a mild recession.

Looking at the world at large, government bonds do not appear to offer a very attractive risk/reward trade off, even if we think that rates will remain lower for longer. Investors will therefore keep looking for higher yields in more risky asset classes. Currently, we think that more value can be found in corporate bonds and sovereign bonds of emerging markets, than in global equity markets.