Idea of the Day European Indices at a turning point

What: European stock indices had been out-performing their US counterparts for most of this year, before struggling in June, as you can see in the chart below, which shows the Eurostoxx 600 index and the S&P 500. The Eurostoxx index has mostly followed the S&P 500 higher this month, but it could be facing a turning point as we lead up to this week’s ECB meeting.

If the ECB fuels further expectation that it is getting ready to taper Its Asset Purchase Programme (APP) later this year then we could see European yields rise, which may weigh on Eurozone stocks. A simple correlation analysis shows that European stocks and German bond yields have had a mildly positive relationship since the start of this year and they have moved together 35% of the time. However, since June the relationship has shifted dramatically, and the correlation between German 10 –year bond yields and the Eurostoxx index is now -30%, which means that as German bond yields rise, European stock indices tend to fall one third of the time.

This shift has occurred at the same time as German bond yields have risen some 30 basis points since the end of June, which may be spooking equity investors and helping to drive investor flows into US equities and out of European ones. Rising bond yields have also triggered a jump in the euro, which is another reason that the Eurozone index may be over.

How: If Draghi and co at the ECB sound hawkish this Thursday, and if Draghi repeats his view that “reflation” is coming back to the currency bloc, then it may be worth thinking about a relative value trade between the Eurostoxx 600 and the S&P 500, as we would expect European stocks to continue to underperform their US counterparts in this scenario. Of course, if today’s CPI data, which saw core prices remain at 1.1%, causes enough concern for Draghi to reverse course on his reflation rhetoric then European stocks could have an initial surge, as it would suggest that ECB QE is sticking around for some time. This may weigh on German bond yields and boost European stocks, if the correlation holds.

Chart 1:

Source: City Index and Bloomberg

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