The so-called "Baghdad bounce" - when the FTSE Eurotop 300 index of leading companies rose by more than 10 per cent - meant that European stock markets enjoyed their best monthly performance in April for 17 years. International investors are now becoming increasingly optimistic that the end of the three-year bear market is in sight.
But developments in the currency markets - where the dollar is almost in free-fall - could dampen that enthusiasm. The sharp rise in the euro against the dollar is already having a strong adverse economic impact on the eurozone. This, in turn, is weighing on share prices. With central bankers, particularly in the US, committed to conquering deflation, their policy response will affect all asset classes.
As international investors become notably less risk averse, many are considering a significant re-weighting of their portfolios towards equities in the belief that the worst of the bear market may be over.
But the US Federal Reserve's determination to combat a slowdown in the rate of inflation - and deflationary pressures - could lend further support to booming government bond prices.
The central bank has signalled its policy bias towards further monetary easing. The currency markets have interpreted this as a sign that the Fed intends to keep US interest rates low for as long as it takes to remove the threat of deflation. The Fed has also indicated that it may take alternative measures to stave off deflationary pressures which could involve buying US Treasury bonds.
But, by hinting at a move into the bond market, the Fed could provide a prop to US Treasuries which many strategists believe are due for a correction. This is because investors may decide to hold on to their bonds in expectation that the Fed may buy them at some point in the future at currently inflated prices. This may delay any reallocation of US portfolios from heavy bond holdings into the equity market, removing a marginal buyer of US shares.
There is probably a cap on the rally in European markets for a different reason. The fall in the value of the dollar against the euro is likely to restrict eurozone economic growth this year.
The dollar has fallen 17 per cent against the euro since the beginning of last year and recently reached a four-year low against the single currency. Merrill Lynch estimates that the strength of the euro will reduce nominal eurozone GDP growth by 1 per cent per year - not only this year but next year too. Nominal growth in the eurozone is currently running at 3.3 per cent.
Although the stronger euro makes euro-denominated assets more attractive for international investors, the poor outlook for the economy is already weighing on the equity market.
Wim Duisenberg, head of the European Central Bank, is not as concerned about falling inflation as his counterpart in Washington, suggesting he is in no hurry to cut interest rates.
The ECB has cut interest rates by 75 basis points in the past year to 2.5 per cent, but the effects of that easing in policy have been wiped out by the stronger euro. Ian Stewart, chief economist at Merrill Lynch, points out that monetary conditions in the eurozone are tighter than they were a year ago.
Ministers in Germany and France - spurred on by their exporters who are feeling the pain - are crying out for a rate cut. The German economy is very sensitive to the export market: a number of companies including Volkswagen, the carmaker, and Henkel, the consumer products company, have already warned of the effects of a stronger currency.
If a stronger euro bites into eurozone corporate profitability while domestic demand remains weak, it is hard to see where the incremental rise in the stock market will come from. Similarly, in the US, corporate profits have been rising - but this is because of company cost-cutting rather than a pick-up in demand. There are few signs that investors are prepared to shed the comfort blanket of their bond holdings in the short term. This, therefore, puts a cap on any further rise in equities.
Global equity markets have been rising on the back of sentiment and some momentum, but economic reality and currency valuations will soon reassert themselves and could disappoint the optimists.
Deborah Hargreaves is the FT's markets editor. Contact: deborah.hargreaves@ft.com
By Deborah Hargreaves
