Bond bubble good for equities

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There is much talk of a bubble in equities. Not so surprising after such a large price increase in such a short time. However, the biggest bubble is in the bond market and the share market will benefit from this in the coming years.

As soon as the nominal interest rate is structurally lower than the nominal economic growth, there is a reflation. Reflation or financial repression is a tried and tested means to solve a debt problem. It does not require the approval of a democratically elected parliament and its power lies mainly in its gradualness. The duration of reflation periods depends on the size of the debt mountain. In the United States, there was reflation for several decades at the beginning of the twentieth century. As a result, investors in bonds lost half of their purchasing power in twenty years. After the Second World War, there was a reflation for more than thirty years. Those who started investing in bonds then, and even reinvested the interest, found out in the early eighties that they had lost two-thirds of their purchasing power, without any major price fluctuations. Today, interest rates are much lower, but there is still a lot invested in bonds. If there is a bubble in the stock market, it pales in comparison to the bubble in the bond market. There are more than 14 trillion euros in bonds with negative interest rates outstanding.

The bond market bubble will not burst in the short term. Central banks will keep interest rates low for a long time and also prevent a rapid rise in long-term interest rates, if necessary by intervening themselves. Interest rates may rise gradually, as long as they remain below the nominal growth rate of the economy. The long-term return prospects for owners of so-called safe bonds are therefore extremely bleak. It is likely that bond investors will move towards equities in the coming years. This is not easy, as regulators are doing everything they can to allow institutional investors to invest in bonds. Regulations such as Solvency 2 and Basel III require a large part of the portfolio to be held in bonds.

Despite opposition from the regulators, institutional investors gradually started investing in equities during the previous major reflationary period. The dividend yield on equities was then also clearly above the interest on bonds and over a longer period the dividend rises, but not the interest. Especially in the Anglo-Saxon countries, shares have gained an increasingly larger weight in the portfolio since the mid-1950s. In recent years, the largest pension fund in the world – the GPIF from Japan – has also started to invest more and more in equities, not surprising given the low interest rates in Japan. The pension reforms in Europe will also make a greater equity allocation possible in the coming years. If all those billions from bonds go into equities, we are probably only at the beginning of the bubble in the equities market.

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