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business newsEuropean Corporate Bonds to Support Stocks
As the ECB isn't in a hurry to withdraw the stimulus, the eurozone will have to find somewhere for the money to go. That "somewhere" is more likely to be in stocks than in corporate bonds given the skinny yields available.
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Let’s cross the Atlantic and head on over to the eurozone, that happy community of people and nations who are forced to pretend they like each other despite centuries of history to the contrary. Our good friends at MSCI-Barra have been thoughtful enough to create an index of eurozone stocks that you can access through the iShares MSCI EMU Index (EZU) exchange-traded fund, and our friends at Bank of America-Merrill Lynch have created corporate bond indices for both investment-grade and high-yield debt in the eurozone.
We can map the three-month-ahead total returns for eurozone stocks against both today’s corporate borrowing costs and the shape of the yield curve in the eurozone as measured by the forward rate ratio (FRR2,10) between two- and 10-year benchmark notes. This is the rate at which we can lock in borrowing for eight years starting two years from now, divided by the 10-year rate itself; the more the FRR2,10 exceeds 1.00, the steeper the yield curve is. The data sample begins in January 1999.
The charts below depict positive prospective returns in blue bubbles and negative prospective returns in white bubbles; the diameter of the bubble corresponds to the absolute magnitude of the return. The last datum used, from three months ago, is highlighted in red-yellow and the current environment is noted with a green bombsight. The red arrow marks the path we've taken over the past three months.
Two things stand out in these charts. First, most of the negative prospective returns occurred when the yield curve was much flatter than today’s very steep level. Second, for the investment-grade issues in particular, the present low level of corporate borrowing costs is associated with positive prospective returns.
Of course, the eurozone has nothing if not event risk. Oddly, the recent kerfuffle with sovereign credit problems contributed to both the ultra-steep yield curve and to the drive lower in corporate bond rates. As the European Central Bank won't be in a hurry to withdraw the stimulus, even though all of those banks passed its rigorous stress tests, the eurozone will find itself in the same situation we've found ourselves in more than once over the past decade: The money has to go somewhere. That “somewhere” is more likely to be in stocks than in corporate bonds given the skinny yields available.
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