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VOL. 39 | NO. 20 | Friday, May 15, 2015

Do not fear Europe’s recovery

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Interest rates determine the cost of capital for corporations, directly influence the capitalized value of corporate earnings and establish relative value positions within the currency markets.

Simply stated, meaningful shifts in interest rates create meaningful shifts in the investment marketplace.

Within the last three weeks, the 10-year US Treasury bond has risen from 1.90 percent to nearly 2.18 percent. That’s a 15 percent move, big enough to capture our attention and capture some ink for this week’s analysis.

Why so High?

The stated purpose of quantitative easing programs is to boost asset prices and economic activity.

Theoretically, large-scale buying of fixed income securities with printed money should reduce longer term interest rates.

However, in practice interest rates have actually risen during periods of quantitative easing. This occurs because forward looking market participants anticipate that the additional stimulus will boost economic growth and inflation. Better outlooks lead to higher rates.

Economic growth and inflation forecasts for Europe have risen substantially within the last few weeks.

After growing a scant .9 percent in 2014, the European Commission recently upped growth forecasts for 2015 and 2016 to 1.5 percent and 1.9 percent, respectively, while boosting inflation expectations to 1.5 percent in 2016.

Even the troubled peripheral nations like Portugal, Ireland, Italy and Spain have seen dramatic improvements in economic indicators and confidence.

Taken together, green shoots have sprouted in Europe’s economic garden. As confidence in Europe grows, longer term interest rates should rise. And so they have.

Over the past three weeks, the yield on the 10-year German Bund has increased from .05 percent to .80 percent.

Given the connectivity of global markets, higher rates in European should produce gains in the Euro (+7 percent), declines in the US dollar (-5 percent), higher commodity prices (oil +13 percent), sympathetic US interest rate gains (10 year Treasury +14 percent) and concerns among stock market investors worldwide (MSCI World +0 percent).

As we can see, the higher rates in Europe have moved things around.

Most notably, the value of the US dollar has fallen, reintroducing inflation concern within the US economy, supporting the Fed’s case for tightening. Ironically, not because the US economy has improved, but because the European economy has improved.

Therefore, rising rates in Europe could lead to rising rates worldwide.

Bottom Line: The gathering recovery in the European economy has led to a sudden surge in European interest rates. This has decreased the relative value of the US dollar, increased commodity prices, increased inflation expectations and US interest rates.

Consequentially, the advance in global equity markets has stalled out as investors determine the tenacity of, and fallout from, the rapid move in rates.

Longer term, economic recoveries that lead to rising interest rates also lead to rising earnings.

The early stage of a rising rate cycle should actually encourage investors as it indicates broadening economic gains. It is the later stage of a rising rate cycle, when capital costs become punitive, when investors need to worry. This is not that time.

Do not fear a European recovery.

David Waddell is president and CEO of Memphis-based Waddell & Associates.

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