Equity Traders See Draghi Turning Throttle Up on Rally

Bullishness is pervading equity markets before tomorrow’s meeting of the European Central Bank.

Shares tracked by the Stoxx Europe 600 Index climbed to the highest level since January 2008. A regional measure of expected volatility, the VStoxx Index, slipped to a six-month low. One-month options in an exchange-traded fund of companies from Sanofi to Banco Santander SA are trading at the steepest discount in more than a year to three-month contracts, data compiled by Bloomberg show.

Optimism has been spiraling higher for a month after Mario Draghi signaled he’s comfortable with cutting interest rates at the ECB’s meeting tomorrow. Pressure for a reduction got stronger yesterday after the European Union’s statistics office said inflation slowed more than economists forecast in May.

“They are pricing in a much better outcome from the ECB meeting than they were a month ago,” James Butterfill, who helps oversee $67 billion as the head of global equity strategy at Coutts & Co. in London, said in an interview. “When you combine that with markets making new highs, that suggests quite a positive outcome priced in for a decision, leaving markets vulnerable to any disappointment.”

The ECB has prepared investors for extra stimulus when it announces the rate decisions tomorrow. “We are ready to act,” ECB Vice President Vitor Constancio said on May 30. President Draghi said following the May 8 meeting that he is “comfortable with acting next time.”

All but five of 52 economists surveyed by Bloomberg predict that the ECB will ease monetary policy tomorrow, according to a poll conducted from May 9 to May 15. Twenty-nine economists forecast the central bank will cut its benchmark rate and deposit rate at the same time.

Inflation Gauge

Euro-area inflation slowed to 0.5 percent in May from 0.7 percent in April, the statistics office in Luxembourg said yesterday. The median forecast in a Bloomberg News survey of 38 economists was for a decline to 0.6 percent. The rate has been less than half the ECB’s target for eight months.

Equities in the Stoxx 600 slipped 0.5 percent to 343.48 following the report, after closing on June 2 at the highest level since January 2008. The slide trimmed the 2014 gain to 4.6 percent. The gauge has increased 25 percent since the start of 2011, trailing an advance of 53 percent in the Standard & Poor’s 500 Index.

The VStoxx, which measures volatility expectations for euro-area equities, slipped 0.1 percent to 16.51 today.

Implied Volatility

One-month implied volatility for options on the iShares MSCI EAFE ETF reached 8.16 on May 30, compared with 11.36 for three-month contracts, data compiled by Bloomberg show. That was the widest spread since January 2013. Near-term options have gotten cheaper and cheaper since Draghi signaled the possibility of easing. One-month volatility stood at 12.07 on May 7, the data show, compared with 12.77 for the longer-dated contracts.

The cost of protection should be higher because slowing inflation suggests growth won’t take hold and share prices have risen too much, according to Emmanuel Bourdeix, who is in charge of volatility investments at Natixis Asset Management.

“European equity markets have had a strong rally,” Bourdeix said in a phone interview from Paris. Natixis Asset Management oversees 301 billion euros ($410 billion). “We do believe that deflation risks and growth disappointment could lead to drawdowns in European equity markets and hence somewhere a spike in euro-area volatility indices.”

Pioneer, AllianceBernstein

Firms from Pioneer Investment Management Ltd. to AllianceBernstein Holding LP say the odds are high that measures the European Central Bank will announce to stimulate the region’s economy will fall short of the bond market’s lofty expectations. Yields on bonds from Belgium, France, Italy and Spain have fallen to records in the past month.

The euro area’s economy will expand 1.1 percent in 2014, according to the median forecast in a Bloomberg News survey of economists. Investors deposited $288 million in the EAFE fund in May, following two months of withdrawals, the data show.

Investor confidence is warranted with central banks around the world supporting financial markets as earnings for European companies improve, according to Joost van Leenders, a strategist at BNP Paribas Investment Partners in Amsterdam.

Profit for Stoxx 600 companies will increase 9.3 percent to 22.39 euros a share this year, the most since 2007, according to the average analyst estimate compiled by Bloomberg.

“If they don’t deliver, then you will see an increase in volatility and it would be justified,” Van Leenders, who helps oversee $643 billion and recommends owning more European equities than reflected in indexes, said in an interview. “But low volatility is also a result of steady improvement in growth. We still believe that stronger growth and stronger earnings could push equities higher.”

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