LIVE MARKETS-Three stages of a rally in euro assets

Welcome to the home for real-time coverage of markets brought to you by Reuters reporters. You can share your thoughts with us at markets.research@thomsonreuters.com

THREE STAGES OF A RALLY IN EURO ASSETS

The rapid rise in European stocks in the early part of the year eased somewhat in the second quarter, with Europe's STOXX 600 .STOXX largely treading water since early May. Inevitably this has led to investors questioning whether the rally is over, or if there is more to come.

Gavekal Research's way of answering is to argue a major rebound in European assets would have three stages, and while the first one has occurred, the other two are still to happen, though they may not at all.

"The first stage is the correction of excessively pessimistic expectations about the euro zone's short-term economic outlook," writes Cedric Gemehl, Gavekal's European economist.

He says this first shift has played out, as the impact of past ECB easing and Germany's fiscal package lifted sentiment, while some downside risks eased.

"The second stage is the removal of the deflationary premium embedded in the price of euro-denominated assets." Gemehl says this is most clearly demonstrated by the region's substantial and persistent current account surplus.

This stage is yet to be completed, as the deflationary premium remains visible in euro zone asset prices. However, "It offers the best opportunity for investors, as there is a solid case that domestic reflation will unfold over the next two to three years."

The third stage, according to Gemehl, is markets pricing in a true economic renaissance in Europe.

But "Such an outcome has shaky foundations and may not happen."

So what does it mean for assets?

While Gemehl thinks achieving the third stage might be a "step too far", he's optimistic about the second. He believes that as it becomes clear domestic deflation is a thing of the past, markets should push up the euro and interest rates, while cementing the leadership of domestically focussed companies in the stock market.

"This shift will not occur all at once," Gemehl says, " but it is likely to be the dominant medium-term trend in euro-denominated assets over the next two to three years."

(Samuel Indyk)

*****

EARLIER LIVE MARKETS POSTS:

A WEEK IS A LONG TIME IN MARKETS CLICK HERE

EUROPE BEFORE THE BELL: FUTURES EDGE UP TO ROUND OFF STRONG WEEK CLICK HERE

TRUMP MOVES TO EXTEND GRIP ON FED CLICK HERE