Equities started off the year on an excellent note in Europe. From January till mid-April, the equity markets in Europe were gaining positive momentum with the DAX Index up 27% in the first three and a half months of the year.

Then earning season kicked in and investors were worried that expectations were too high and there could be a correction. However, corporates did not disappoint. Although we didn’t see companies report results above expectations, investors were happy because expectations were already revised upwards throughout the initial months of the year. So in reality companies did outperform initial expectations.

However from mid-April to date the DAX Index lost circa 8.5%. What went wrong? Wasn’t quantitative easing meant to remove all doubts? And shouldn’t equity markets have continued to rally?

When the market started selling off, I must admit I couldn’t come up with an immediate answer that made much sense. There was quantitative easing in Europe, positive signs of an improving European economy and companies reported results in line with expectations.

However, there is always a reason for every selloff and further analysis led me to come up with two reasons which caused the drawdown in European equity markets.

The first - An increase in yields on European Sovereigns

From mid-April to date, the yield on the 10-year German bund increased from close to zero to nearly 1%. Yields on the bund increased for two main reasons;

The first being an improvement in economic data coming out of the Eurozone with investors factoring in higher inflation rates which automatically results in higher yields.

The second being the Fed potentially raising rates in the US. Although there is debate whether or not the US will be raising rates sometime this year, there is general consensus that the US economy is ahead of Europe and rates will rise eventually. This would result in investors selling out of the lower yielding economy (Europe) and investing in the higher yielding economy (US). This shift out of Europe and into the US will cause selling pressure on yields in Europe sending them lower.

How does this impact equity markets negatively? If yields rise, so does the equity risk premium used to discount cash flows. This means that equity valuations will be lower than initially expected when yields on the bund where close to zero.

The second – A black swan event – Greece leaving the Eurozone

I do not expect Greece to leave the Eurozone. They have more to lose out of the union than in it. Nevertheless, the fact that the Greeks are taking much longer than the market expected to come to a compromise is causing volatility in the markets.

My opinion is to keep holding onto your European equities and if you are not exposed, this is the time to do so.

I do not expect Greece to exit the Eurozone and the volatility in the market has created a buying opportunity.

Secondly, if yields on European sovereigns had to rise because of an improvement in European data, European corporates will benefit from this in the longer term.

This unexpected phenomenon of increasing yields in Europe is a snapshot of what’s influencing the markets today. At this stage in the cycle, equities should outperform other asset classes. Though you have to stay the course and take a long term view. Don’t forget a business cycle takes 9-11 years to go through from trough to trough or peak to peak. Be patient.

Kristian Camenzuli is Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.