The recent sharp fall in bond prices, which saw yields on German bunds climb to a six-month high of 0.72% on 13 May 2015, caused a long-anticipated consolidation in European equities. It also helped the euro to strengthen, stopping the US dollar rally in its tracks, in spite of continued nervousness over Greece.
Along with these moves, the oil price rallied and many stocks that outperformed during the first part of the year went into reverse. This triggered warnings that the equity rally may be over. I disagree: I think this has been a necessary breather, before we see a continuation of better economic and profits news over the next few months.
The return of pricing power
There are signs that inflation is picking up. European Central Bank (ECB) President, Mario Draghi, flagged up at the ECB Governing Council meeting on 15 April that inflation rates are 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 a moderate level of 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 large number of investors) look fine until there is a stampede for the exit. So perhaps there has been an element of this in recent moves.
Economic indicators remain supportive
For the medium and long-term investor it is perhaps more important to look beyond short-term trading noise and consider whether the gradual improvement in economies will continue. 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, impacted by port strikes and bad weather. This should reassure investors that US monetary policy is likely to remain accommodative.
It is clear, however, that European markets have moved on. The MSCI Europe Index 12-month forward price/earnings (P/E) ratio is close to 16x earnings – higher than average, but not necessarily a cause for concern 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% in the coming years, if the “rule of 20” (a view that the stock market is correctly valued when the average P/E plus the rate of inflation equals 20) holds true, European markets can become more expensive in terms of P/E ratios. From a dividend perspective, yields on European equities also remain well ahead of those on German 10-year government bonds (3.1% average for the MSCI Europe Index, as at 30 April 2015, versus 0.6% for bunds, as at 15 May 2015).
European politics: certainty and uncertainty
On the political side, the election of a Conservative government in the UK maintains the status quo. There is a risk that the new government could be pulled towards the Right by those members with an anti-Europe, anti-welfare mandate, but my suspicion is that David Cameron and his allies know that UK elections are won and lost in the middle ground. There is a possibility that the “in/out” referendum on Europe, scheduled for 2017, could go the wrong way for markets (i.e. the UK decides to leave Europe), but my view remains that the UK is better off in a properly functional European Union. I also accept, as do most European leaders, that Europe needs to undertake further serious – and successful – reforms.
Greece, as always, remains a problem. The impasse between Prime Minister Alexis Tsipras, who refuses to accept the need for fundamental reforms, and the International Monetary Fund and ECB, who have refused to provide further financial support until reforms begin, looks set to continue. If Greece wants to stay in the euro, it must adopt reforms and prove that it is heading in the right direction, as far as budget stability is concerned. Sadly, the current Greek government has reversed the progress made by previous administrations, making the situation even worse for the long-suffering Greek people.
The European story continues
Putting it all together, recent signs of strength in European economies, coincident with weaker-than-expected growth in China and the US, have led to a logical shift in sentiment. Further good news should be still to come from European equities, including an increase in merger and acquisition activity, while the ECB continues to press ahead with its monetary stimulus programme. Furthermore, the current trend, whereby money is flowing from bonds into equities, should continue. This is hardly surprising given the different expectations for each asset class over the next 12 to 18 months.
In my view it is too early to be scared about a return to a slightly more normal economic environment. But we remain wary of the “crowded trade” effect, which is likely to fuel bouts of higher market volatility from time to time.
Tim Stevenson is manager of the Henderson Horizon Pan European Equity Fund at Henderson GI.
