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Bond Bullishness?
Toronto: May 19, 2014
By John Stephenson

Despite persistent calls for bonds to stumble, bond yields hit ten month lows this past week.  Most forecasters entered 2014 with the view that bond yields would slowly grind higher, but a potent combination of soft European and U.S. data, heightened geopolitical tensions and an ECB that seems ready to jump into the fray of quantitative easing saw bonds rally and yields slump over the past week.

While yields in the U.S. have fallen, briefly closing below 2.50% for the U.S. 10-year this past Thursday, it’s European yields that are the big story. In Europe government bond yields have been falling relentlessly for the past two years.  It wasn’t all that long ago that Europe appeared to be the epicenter of an emerging global financial crisis.  Fear of a European meltdown sent the yields on government bonds of the highly indebted peripheral nations soaring.  But today, things are different.  Italy’s10-year borrowing costs now stand at 2.90% down four full points from their level in 2011 and 2012, when the country was on the verge of a bailout. 

Even Greece, which has suffered through a six-year depression, not to mention being the recipient of two bailouts and a debt restructuring, was recently able to raise debt on its own.  The country recently was able to do a debt deal with its five-year paper yielding just below 5 percent.  Portugal is on the rebound too with its recently priced two-year bonds trading at a scant 1.2 percent. 

Driving the strength in European government bonds has been Mario Draghi the president of European Central Bank (ECB) who, in the summer of 2012, promised to do “whatever it takes” to keep the euro zone intact.  The promise was backstopped by a pledge to buy, in unlimited quantities, the debt of any country having trouble financing itself.  The gradual end to the recession in Europe did the rest.

As bonds rallied, stocks stumbled with the stock market growing increasingly anxious that a weakening U.S. and global economy could dash hopes for an uptick in corporate earnings.  Adding to the mounting worries of equity investors was the latest round of economic data, which showed weakness in Europe and China.  The latest GDP figures for the Eurozone showed a scant rise of 0.2%, half of the market’s expectation, suggesting that growth may be slowing. To help whether the storm, global money managers have been boosting portfolio cash weights, up from three to five percent on average.

Yet the markets adopted a steadier tone by the end of last week as participants looked back over a week that saw expectations build that the European Central Bank would unveil a package of economic stimulus measures next month, after the release of weak Eurozone GDP data.  That speculation helped drive the yield on the benchmark 10-year German Bund to its lowest level in a year. 

While bond bulls have had it their way so far this year, don’t expect the momentum to continue.  Corporate earnings have been beating expectations by more than usual in both the U.S. and Canada this quarter, with S&P 500 earnings growing by 6.1%, driven by strong margins (nearly 5.8% upside from expectations).  The prospects for stocks is likely to get a whole lot better as 2014 unfolds and the American economy recovers from a weather-afflicted first quarter that saw GDP growth of just 0.1%. 

Despite the uncertainty out there, I remain bullish on the prospects for stocks.  Some economic forecasters are calling for nominal GDP growth in the United States to rise from 3.1% in mid-2013 to 4.8% by late 2015.  Historically, every 1% change in nominal GDP drives roughly a 6% change in earnings for the S&P 500.  Most of this upside is not yet reflected in analyst estimates, creating an opportunity for equity investors to profit.
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