Value at risk

Sliding markets may just reflect a reality check

Investors are losing money and struggling to understand why. The latest selloff is worst in the market for high-grade government bonds, but stocks are suffering too. The Stoxx 600 index of leading European shares fell 1.3 per cent by Tuesday's close and is off more than 4 per cent since April 15.

The bond market moves are more alarming because safe fixed-income assets have been trading at supercharged prices. The yield on 10-year German bunds, for instance, was under 0.1 per cent on April 20. It is now approaching 1 per cent. Bond prices have fallen commensurately.

Exactly why is a bit of a head-scratcher: there's no unexpected bad news to blame. While US monetary policy may be on the path to tightening - which would tend to fit with higher yields - the European Central Bank's version of quantitative easing has only just started, which ought to point the other way. The rise in the price of oil may be feeding investor expectations of higher inflation, with a knock-on effect on yields. But there's no clear reason why the cost of crude is rising, either.

European equity prices may be looking more vulnerable, at least in part, because safe-haven bond prices are lower and yields higher. But that still doesn't explain why bond prices are falling. World economic growth is set fair, if only lukewarm - the latest IMF estimate is 3.5 per cent, with an improving outlook for advanced economies.

However, by almost any historical standard, high quality sovereign bonds are still expensive, considering the long-run average bund yield is nearly 4 per cent over 20 years and over 6 per cent since 1965. Yields are, of course, related to broader economic conditions. If nothing else, though, the current gap between the bund yield and the 10-year US Treasury yield, which is running above 2.2 per cent, is striking.

The Stoxx 600 index, meanwhile, trades on a multiple of 16.4 times estimated earnings. That makes it around one-quarter more expensive than the 12-year average. In the five months before the index peaked in April at 414, it had risen 28 per cent.

A Picasso painting fetched an all-time record of $179 million at auction on Monday. Investors don't need bad news to make them rethink their appetite for bonds, equities and other assets. They may just be reality-checking high valuations.