Europe Bumps Up Rates, Throwing Investors a Curve

The Federal Reserve Board’s inflation paranoia appears to be catching on, and it’s making for another round of misery in stock and bond markets worldwide.

In a shocker Thursday, the central banks of Sweden and Italy separately raised short-term interest rates--the first increases in European short rates since autumn of 1992. Predictably, stock prices tumbled in Europe and long-term bond yields soared on the news.

In language all too familiar to Americans this year, both the Swedes and the Italians cited the need for higher rates to head off inflation as the world economy picks up steam.

Internal politics also may be guiding the authorities at Sweden’s Riksbank and at the Bank of Italy: The budget deficits of both countries have been ballooning, and the central banks are trying to make clear to their governments that the price of continued heavy deficit financing will be higher interest rates, economists say.

Still, there is enough strength in the European economy this summer to make the inflation concerns of the Riksbank and the Bank of Italy believable. Believable, if not justifiable in the eyes of many global investors.

*

Indeed, just as critics of the U.S. Fed have contended that Chairman Alan Greenspan sees inflation where it doesn’t exist, many investors in European stocks argued Thursday that the Swedes and Italians are jumping the gun, endangering an economic recovery that began only this year.

Higher rates “just don’t make any sense from an economic point of view,” said Malcolm Clinger, chief investment officer for Swiss Bank Corp.’s private banking unit in New York.

David Peebles, manager of the USAA Investment International stock fund in San Antonio, also expressed surprise at the rate hikes and noted what the disheartening outcome is likely to be: an end to what had been widespread expectations that European interest rates could still move lower this year, especially in the key economies of Germany and France.

In theory, rates in Europe are already too high, given the Continent’s generally low inflation rates and high unemployment rates, the latter a seeming guarantee that huge labor surpluses exist and will keep wage inflation nonexistent in Europe.

Until the Swedes and Italians made their moves Thursday, investors like Peebles had been betting on European stocks in part because the interest rate outlook appeared favorable at best and neutral at worst, especially compared to the rising-rate environment of the United States.

Now, some global investors admit they must rethink Europe if higher interest rates are coming this soon in an economic recovery. British stocks may be most vulnerable, because Britain is further along than the Continent in recovery and thus more prone to inflationary pressures and rising rates. “We will be cutting back our U.K. stock holdings” today, Clinger said.

But is a turn in European short-term interest rates enough to bring on a full-blown bear market in stocks there? On that question, the U.S. experience may be a good model. While the U.S. market has been in turmoil this year, most broad stock indexes are off only marginally measured since Jan. 1. And while it hasn’t been easy to make money in U.S. stocks as interest rates have risen, savvy stock pickers have done it.

Most European markets are already down more this year than the U.S. market, correcting some of last year’s surge. From here, some pros say the right approach to European stocks is to view that economy in the same light as the U.S. economy: It’s growing, and it will continue to grow even as the central banks work their sorcery with interest rates. A recession soon is not in the cards.

That means European corporate earnings will rise into 1995, assuring there should always be something for stock investors to get excited about--if only during interest rate lulls.

Anthony Cragg, manager of the Strong International Stock fund in Milwaukee, says an interest rate turn in Europe means “we’re past the point of buying lousy companies for a turnaround”--a relatively easy game, he notes. Now the turnaround is here, and stock picking gets much tougher, Cragg says. For global mutual fund managers, this is when the true pros are separated from the amateurs and pretenders.

The Rate Conundrum

European short-term interest rates--already well above U.S. rates--are rising again, though inflation remains low in Europe and the unemployment rate is sky-high.

Short-term interest Inflation Unemploy. Country rates rate rate Italy 8.5% 3.6% 11.6% Sweden 7.4 2.5 8.5 Britain 5.6 2.6 9.4 Canada 5.5 nil 10.3 France 5.4 1.8 12.6 Australia 5.4 1.7 10.0 Germany 5.0 2.9 8.4 United States 4.5 2.5 6.1 Japan 2.2 0.6 2.9

Short-term rates are three-month money market rates. Inflation and unemployment rates are latest annualized figures.

Source: MSI Global