Is the euro area’s continued equity rally overdone – particularly given the dismal economic reality in Europe’s south? Was Japan’s stock market surge just another of its many “false dawns”? These were among the questions most frequently asked by investors recently. If we ignore the daily doses of noisy data and news, and focus on the bigger picture, we should be able to let the markets provide the answer. In both cases, it is a clear and consistent “no”.
For the most part since the start of the year, a consolidative/correcting mood prevailed in many stock markets, while a number of emerging markets continued to extend losses (table, page 4). By contrast, European equities continued to advance and outperform, led by gains in the Southern countries and Ireland. In fact, the euro periphery’s leadership has been steadily expanding in both strength and breadth over the past two years. Initially, this broader shift was easier to overlook, as it concerned only Greece and Spain. These two markets began outperforming in May and July 2012, respectively. Ireland and Italy joined the outperformers in 2013, with Portugal duly following suit this year. Yesterday’s losers are now being traded as tomorrow’s winners – in a remarkably consistent pattern across regions and asset classes. For example, this pattern is also evident in the government debt markets.
At the same time, during this specific period, a number of important euro area economic data have been rather weak, and there is a mismatch between what the market sees and what people are talking about. In most discussions, the predominant European theme is still a very negative one – namely the potential for a European descent into a Japanese-style deflationary stagnation. The talk among experts is not about the South overcoming the long stretch of misery – but about it dragging the entire continent into doom. Given this background, it seems natural for people to be concerned about the risk of an undue optimism in markets. In practice, however, such contests of contrasting visions are often – if not always – won by the markets.
The markets themselves are clearly dismissing any such concerns if we look at the bigger picture. In the context of today’s global bull market, which is quite pronounced in practically all developed markets, the euro area’s equity rally has actually been very moderate and modest so far (see chart 1, page 2). At best, the Eurozone has finally started to gradually stabilize relative to the other industrialized countries – far from any exuberance, that just implies investors have started to realize the euro area isn’t worse off than the US or Japan. Europe’s rebound is certainly more pronounced and robust when compared to Asia and the emerging markets – but only in the context of the long and steady European retreat over the preceding decade. In short, the medium-term uptrends in Europe are still rather young and moderate, although they are by now quite firm, well-defined, and increasingly broad-based (for visualization of these trends, we use twelve -month moving average relative prices, see page 2).
The European example only reminds us that we should not forget the broader context of current market developments. Recent events only appear as potentially exaggerated or unjustified because people have mostly recent and/or current economic conditions in mind, while markets reflect expectations of the future developments, including relative changes. Meanwhile, the potential magnitude of shifting future expectations heavily depends on the past. When the circumstances are right, a region that is just struggling its way out of a deep crisis, and/or has been underperforming for years or decades, has a correspondingly large potential for a strong and lasting comeback – and current relative trends illustrate that the euro area has thus far realized only a fraction of that potential.
Last but not least, the same is also true for Japan – where the relatively young medium-term uptrends remain unbroken, while the great stock surge of 2012-2013 was still humble in the bigger picture (see figure 2, page 1).
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