The DAX just keeps on climbing. Freed from the fears of a European political swing to the right after France’s election, Germany’s leading stock index has set one record after another in the last few weeks. Since the start of this year, the index of Germany’s 30 largest companies on the Frankfurt Stock Exchange has grown 11 percent, pushing the index to 12,783 points. In the last 12 months, the DAX has climbed about a quarter.
The impressive gains are fueling a new round of optimism for the coming year. Numerous banks have raised their forecasts for 2017 by about 1,000 points. These optimists see the DAX around 13,500 points by year’s end, thanks both to less political uncertainty and a strengthening German and European economy.
For some, the optimism goes even further: Some analysts are starting to call 2017 a turning point after six weak years: "More economic growth and growing company earnings are currently pushing stock markets to new heights," said Ulrich Stephan, chief investment strategist at Deutsche Bank.
Any shift from Mr. Draghi in June would signal that the end of the ECB’s exorbitant flood of money is getting closer.
Indeed many European companies are earning solid profits again, and analysts expect corporations will increase profits by double-digits this year, too. Analysts see the 30 companies listed on the DAX index leading the way. It’s also true the DAX isn’t exactly overvalued. The average share has a price-earnings ratio of nearly 14 relative to profits. That’s inexpensive both compared to US stocks and to what they have cost in the past.
And yet, a continued rise in stocks is a daring forecast to make. Not all is as rosy as it seems in Europe, and there’s one other key headwind blowing against the DAX: A possible reversal of monetary policy at the European Central Bank.
There’s little expectation the ECB will actually raise its prime interest rate from a current low of 0 percent before 2018. But something else could happen in the meantime: Several high-ranking managers at the ECB recently indicated that ECB President Mario Draghi may reassess his view of the euro zone economy in June. For some, this has been interpreted as an initial signal of a turning point in the way the central bank thinks.
Not that Mr. Draghi is fueling the fire as of yet. Until now, the head of the ECB has emphasized that the economy is not yet standing on an unshakable foundation – and he didn’t change this view in a speech before the Dutch parliament on Wednesday. The ECB president spoke about diminishing downside risks, but also of the necessity of maintaining the ECB’s “substantial” monetary stimulus, which has involved injecting well over €1 trillion into the 19-nation euro zone’s economy over the past two years.
But increasing growth in the euro zone, coupled with a recent annual inflation rate that climbed to 2 percent – albeit briefly and largely due to oil prices – have led the warnings to grow louder. Even a slight change in the ECB’s economic outlook – from a focus on the downsides to a more neutral stance – could be what sparks the ECB to start down the path of easing back on its ultra-loose monetary policy, buying fewer government bonds and, eventually, raising the prime interest rate.
Why does this matter for the DAX? A mere change in tone from the ECB could have an impact on both the stock market and bond market. Indeed it’s normal for investors, who invest in the future on the stock market, to react immediately to announcements by monetary policy officials, sometimes even more drastically than when words become reality.
Just look across the Atlantic. In May 2013, then-Federal Reserve chairman Ben Bernanke caused stock markets to slump and bond returns to soar merely by saying he was thinking about tapering the Fed’s own bond purchasing program. The Dow Jones Index fell about 4 percent heading into June of that year and the DAX followed it. When the Fed actually did begin tapering its bond purchasing at the start of 2014, stock markets fell again, though bond prices held steady.
For the euro zone, any shift from Mr. Draghi in June would signal that the end of the ECB’s exorbitant flood of money is getting closer. When that day comes and interest rates begin to rise, financing for companies will become more expensive. If that happens, then today’s DAX could let off some of the steam that has been pumped into stock markets by the ECB’s low-interest policy, says Tobias Basse of NordLB. A quicker than expected rise in US interest rates could have a similar dampening effect, he adds.
This danger is especially real in Germany, where cautious investors have been driving up the stock simply for lack of viable alternatives. Once rates rise, safer options like government bonds will become more palatable again.
Still, few analysts believe there is a threat of a long-term slump of stock prices. If Mr. Draghi were to announce the start of the end of the ECB’s loose monetary policy, it would be a signal that things are returning to normal. This “normality” is already becoming something of a reality today, because Europe’s economy is growing again and companies are doing solid business. Even the less optimistic equity strategists believe the DAX will roughly maintain its current level to the end of this year.
Of course, there is one thing that could work against that optimism, aside from the ECB: Parliamentary elections are coming soon in France and Germany. Any false move and political uncertainty could come storming to the forefront for investors once again.