Europe's equity rally on tenterhooks A summer fling or the start of a lasting relationship? European shares have rallied strongly in recent weeks as investors have fallen out of love with developing country equities - and looked longingly at Europe's improving economic prospects. The FTSE Eurofirst 300 is up 10 per cent since late June, compared with 5 per cent in the US's S&P 500. Spain's Ibex and Italy's FTSE MIB indices are both up more than 16 per cent. But this week the rally has hit a rocky patch. A global surge in bond yields, led by US Treasuries, raised fears that central banks had lost control of market interest rates and jeopardised fragile economic recoveries. European shares ended the week broadly unchanged compared to a week ago, with UK equities among the biggest fallers. Just as Europe surprised on the upside when global sentiment was favourable, the risk is that underlying weaknesses in the continent's economies and banking system leave them exposed to corrections. For the moment, strategists see little immediate danger. Now that Japan has run out of steam, people are looking for a new macro theme . . . Europe still faces many, many challenges, but it's perhaps not quite as bad as some people thought, and that's enough for a rally," says Robert Buckland, chief global equity strategist at Citigroup. Europe was trading at a 30 per cent discount to US equities a year ago, he says. Now it's just 10 per cent. Ewen Cameron Watt, chief investment strategist at BlackRock Investment Institute, adds: "Europe is benefiting from investment tourists moving in search of inexpensive cyclicals." Recent weeks have seen the strongest inflows into western European equity funds since early 2008, according to EPFR, the funds data supplier, attracting a net $8.3bn since July 1. From the start of the year, inflows into Spanish funds have been equivalent to more than 10 per cent of assets under management; Greek fund inflows almost 80 per cent. Adding to evidence that investors are rethinking long held views, France's CAC 40 index has risen 13 per cent since the start of the year - "quite a thumping outperformance from a country that had been broadly written off," says John Bilton, European investment strategist at Bank of America Merrill Lynch. Germany's Dax, which flatters share rises by including total returns through dividends, is up a more modest 10 per cent. The danger is that investor sentiment proves fickle. European shares may have benefited from a political lull ahead of Germany's federal elections on September 22. Andrew Milligan, head of global strategy at Standard Life Investments, says: "It is very clear that a lot of decisions have been fudged or pushed under the carpet. Greece was given extra money despite not ticking all the boxes. There has been too little lately from the European Commission on a whole range of key issues, noticeably banking reforms. Nor has the second quarter European corporate earnings season been brilliant. The proportion of companies beating earnings per share forecasts, at less than 50 per cent so far, is below the historical average, according to BofA Merrill Lynch. In the US, it has been in line with the average. On top of all that, market borrowing costs are rising steadily. This week markets have tested the "forward guidance" given by Mario Draghi, European Central Bank president, and Mark Carney, the new governor of the Bank of England, which was meant to reassure markets that interest rates would remain low for a protracted period. "I'm amazed how many people think that equities can carry on up despite higher bond yields," says Graham Secker, European equity strategist at Morgan Stanley. It is quite likely we will see a correction [in European equities] in the next month or so - sentiment is quite elevated. Still, higher market interest rates need not spell disaster - particularly if the economic recovery story remains intact. "On a six month view I think the outlook for European equities is still positive and they will outperform the US," says Mr Secker. When the macro outlook is improving people like to buy laggards, they like the reversion-to-mean story. European share prices have surged simply because previously the region's economic outlook was so bleak - so there was scope for catching up. Compared with the US, European equity markets are more cyclical and more exposed to low quality financials, so in an environment where confidence is improving you would expect Europe to outperform. On the other hand, you are less protected when things go wrong," says Robert Farago, head of asset allocation at Schroders private bank. BlackRock has a team parsing European company conference calls, says Mr Cameron Watt. They have noticed a pick-up in optimism - not in formal statements but the language used. Company executives are not jumping up and down for joy but they are more optimistic than six months ago - more so in southern Europe but that is because sentiment was so depressed there. Mr Buckland at Citigroup concludes: "Europe is the trade for people who want to be a little bit contrarian, but aren't brave enough to buy emerging markets quite yet."