Low bond yields support equity rally

Investor/An insider's guide to the market: In 2004 the much-anticipated rise in government bond yields failed to materialise, but at the start of 2005 many analysts clung to the view that such a rise had been merely delayed until 2005.

Such expectations have proved to be wide of the mark and on the contrary euro-zone bond yields have actually fallen by approximately 50 basis points since end-2004 and by a lesser amount in the UK and US. The modest falls in US and UK yields are particularly significant given that short-term interest rates have been rising in both countries.

In the euro zone, the European Central Bank has been firm in its view that it saw no room to lower short-term interest rates to below 2 per cent. However, recent comments from ECB chief economist Otmar Issing seemed to raise the possibility of a cut in rates.

The rally in the euro-zone bond market this year largely reflected expectations that official ECB rates would rise by up to 50 basis points by the end of the year; however, these have now given way to a risk that the next move could be a rate cut.

These divergent trends between European and US interest rates have been the key factor in fuelling the ongoing rally in the US dollar exchange rate.

Several downward revisions to economic growth forecasts for 2005 and 2006 have created the conditions for this fall in the value of the euro. Investors usually associate lower economic growth with lower profit growth leading to weak share prices. In fact, the opposite has occurred in 2005 and most European equity markets have risen by approximately 7.5 per cent so far in 2005 and are now at three-year highs.

Despite weak economic growth, companies have been able to achieve strong profit growth that must be due in part to the weaker euro. The relative valuation impact of lower bond yields has been another positive influence on share prices.

The equity earnings yield/ bond yield ratio is a widely used method of comparing the relative attractiveness of bonds and equities. The earnings yield is the inverse of the familiar price earnings ratio (PER). The current European PER of 13 translates into an earnings yield of 7.7 per cent.

This is well over twice the 10-year bond yield of 3.3 per cent and at face value indicates that European equities offer much better investment value than European bonds. In Investor's view this valuation support for equities is likely to push European equity markets higher over the remainder of this year.

However, the persistence of very low short-term interest rates and bond yields does pose question marks over the sustainability of any strong rally in euro-zone equity prices. Bond yields at current levels or lower are only consistent with an environment of persistently weak economic growth.

If Europe's growth performance improves, it would soon be accompanied by rising interest rates and bond yields, which would make equities less attractive compared with bonds.