The recent sharp fall in bond prices, which pushed German 10-year yields up to a six-month high of 0.73 per cent on 13 May 2015 has caused a long-anticipated consolidation in European equities.
It also helped the euro to rally higher against the US dollar, halting the US dollar rally in its tracks, in spite of continued nervousness over Greece.
Along with these moves, the oil price has picked up, and many stocks that outperformed during the first part of the year have gone into reverse. This has triggered calls that the equity rally is over. I disagree: I think this is a necessary breather, before we see a continuation of better economic and profits news over the next few months.
First, there are signs that inflation is picking up. ECB president Mario Draghi flagged up at the ECB Governing Council meeting on 15 April that inflation rates were expected to “increase later in 2015 and to pick up further during 2016 and 2017”.
This is good news for equities – suggesting a return of pricing power. It is also positive for economies, because “some” inflation is probably the most palatable way to begin eroding the vast amount of government debt built up globally over the past 25 years or so.
Inflation is, however, not good news for those who, spurred by deflationary fears, bought any of the high number of bonds that have started to trade on negative yields. These so-called “crowded trades”, where a position, whether short or long, is held by a majority of investors, look fine until there is a stampede. So perhaps there has been an element of this in recent moves.
For the medium and long-term investor it is perhaps more important to look beyond short-term trading activity and consider whether the gradual improvement in economies continues. Recent data shows that European economies are getting better, albeit slowly, and an expected interest rate hike in the US may be postponed due to the country’s weak start to this year, thanks to port strikes and dreadful weather. This should reassure investors that the monetary stimulus will not be choked off too early.
It is clear, however, that economies and markets have moved on. Europe now trades at close to 16 times price/earnings ratio forecasts – higher than average, but not necessarily that scary as long as P/Es in the US remain higher. Furthermore, European companies are at the start of a period of recovery for profits.
Even if inflation reaches 2 per cent in a year or two, if the “rule of 20” holds true – a view that the stock market is correctly valued when the average P/E plus the rate of inflation equals 20 – European markets can become more expensive. From a dividend perspective, yields on European equities also remain well ahead of those on German 10-year bonds – 3.1 per cent versus 0.6 per cent, as at 15 May 2015.