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After the correction in May, European equities look cheap in a historical context. With price/earnings ratios below the historic average and with many companies paying dividend yields which are higher than their bond yields, there is a lot of value around. Furthermore, the global economy is recovering en corporate balance sheets are strong. So, equities appear to have been punished too harshly for the worries about eurozone sovereign debt. Do investors worry too much?

Markets are forward looking and they clearly do not have much trust in the analyst forecasts for earnings in 2011. One can indeed wonder if analysts take sufficiently into account the negative effects of all the debt reduction measurers which European countries plan to take in 2011. But, even if we would get a temporary double dip and less than half of the 20% forecasted earnings growth, equities still look quite cheap.

Or could it be that there is a deeper worry? About a threat which is mostly met by denial, but still hides like a mythical monster in the sea of debt? About a threat which would justify below-average equity valuations? A threat called ‘deflation’?

In reality, fears of inflation are still being voiced much more widely, especially when central banks put the printing press on. Even so, both bond yields and inflation data have been heading south, at least in the US and the eurozone. People tend to forget that printing money does not create inflation, only spending does. As long as consumers remain cautious and save rather than spend, inflation is not an issue.

In a debt-rich world, countries have an incentive to try to inflate themselves out of their debt. However, you cannot create inflation at will, just ask the Japanese! One of the reasons for the stubborn deflation in Japan is the aging population. An aging society gradually needs less new houses and new cars, less labour/commodity intensive products (which tend to be major drivers of inflation). Conversely, an aging society needs to own huge amounts of low risk investments in order to secure a steady income for all the pensioners. Therefore the Japanese are still happily buying their local government bonds, even if they yield hardly more than 1% in a nominal sense. After all, if deflation is 2%, the real yield on their bonds is still 3%!

Why is this relevant? Well, as it happens, the demographics of the eurozone now look the same as Japan in the early nineties. The aging society, with its deflationary tendencies, is slowly becoming a reality, also in Europe. Furthermore, the spending patterns of the all-important German consumers remind us of what we saw in Japan. Real consumption growth in Germany is already stagnant for ten years and the Germans share quite a few behavioural characteristics with the Japanese. Both are people who – more than average - want to be in control of their life and their future, also in a financial sense. Saving may now come more natural to them than spending. There is certainly nothing wrong with such financial prudence, but the Japanese have proven it to be a potential recipe for deflation.

So maybe the present low bond yields in Germany are not only the result of a save haven status, but also the first post-war signs of deflationary tendencies. In this case, equity valuations should indeed be somewhat lower than their historical average. In this case, bond yields below 3% can still be defended. Time will tell, but the recent behaviour of financial markets may be more rational than it appears on first sight.