All major European stock markets fell last week, dropping as much as 5.6 per cent in Spain, 3 per cent in France and the Netherlands, 2.5 per cent in Germany and 1.35 per cent in Britain as investors faced bad news on all fronts. The Italian government collapsed, interest rates rose in no fewer than six European countries and US Federal Reserve chairman Alan Greenspan said that with more people in work, US wages could rise, triggering higher rates.
Even though investors blanched and tightened the purse strings last week, some are now choosing to hold or even boost European stock exposure.
"We were surprised by the German move, but not shocked. The underlying European economy is strong enough and the rate rise has come early enough that we don't expect there'll be a follow-up of sharp increases," said Felix Lanters, European equities manager at ABN Amro Asset Management. "We can no longer count on falling interest rates to help stocks, so performance will depend on good profit growth, and that's what we expect to see."
Mr Lanters is not alone. Several investors on both sides of the Atlantic that are betting that European companies will continue to drive profit growth and push share prices higher, surpassing returns generated from investing in US equities.
"People aren't giving enough weight to what is going on in the US," said David Harris, European equities manager at New York-based Stein, Roe & Farnham Investment Management. "People are looking at the US through rose- coloured glasses and are buying on the dips. The valuations are too high."
The US Labor Department said prices paid to factories, farmers and other producers rose 0.5 per cent in September, surpassing the 0.2 per cent increase anticipated by analysts. "The US has under-reacted this time. It's getting too frothy," said Mr Harris. "Europe might see a healthy short-term pause, but I don't see a prolonged bear market. Europe is still more attractive than the US."
The Dow Jones Industrial Average ended the week virtually unchanged from the start, but it seesawed between single-day gains and losses of more than 1 per cent on four days, pulled and pushed by a combination of better- than-expected earnings coupled with inflation concerns.
The producer prices report came a day after Germany's Bundesbank raised interest rates for the first time in five years, sparking a series of rate increases in France, Denmark, the Netherlands, Austria and Belgium. That dented bond markets round the globe. German and French bonds led falls in Europe, with the yield on the benchmark 10-year bund rising 6 basis points to 5.62 per cent and the yield on the 10-year OAT up 4 basis points to 5.62 per cent. The yield on the 30-year Treasury jumped 7 basis points to 6.42 per cent.
The attraction of bonds is diminishing as they are unlikely to repeat the handsome gains seen so far this year. Rising interest rates reduce the attractiveness of fixed-income securities. "Any numbers that are worse than expected are going to push the markets lower," said Phyllis Reed, a bond strategist at BZW. "There's a lot of sensitivity to these reports. The market had got complacent about inflation."
That may prove to be a boon for equities. "In the end, where else will investors put their money?" asked Eugen Melliger, a fund manager at Credit Suisse.
One major question looming over Europe is Italy, as President Oscar Luigi Scalfaro began meetings to form a new government, replacing that of Prime Minister Romano Prodi, which fell on Thursday amid budget rows. Prodi's centre-left government stepped down yesterday after losing the backing of its coalition partners of the Rifondazione Comunista party, who refused to back welfare cuts. Elections cannot be held until late November.