Why valuations are not as stretched as they seem
Europe’s P/E has doubled since the lows in 2012; we believe any value case now rests increasingly on low bond yields and/or earnings catch-up. We expect bond yields to rise but only modestly given the ECB’s commitment to sovereign purchases. But low yields are unlikely to be a driver of further equity re-rating, in our view. Indeed we expect earnings to be the main driver of performance especially for the Euro area and periphery. These markets have operational gearing
and lead indicators point to earnings improvement; moreover their Shiller P/Es are below average.
* Value has disappeared...
With the P/E ratio now at 16.2x many investors argue that there is no value in European equities and it’s only with reference to low bond yields that equities continue to be attractive. We have some sympathy with this view – the ERP remains high (c.7.3%). And while the risk premium should come down in future years as growth improves and deflation risks recede, this may not help to reduce the cost of equity if bond yields also rise to reflect better nominal growth.
* ...but plenty of earnings potential
We continue to see value in Europe in terms of earnings catch-up and lots of recent lead indicators point to a turn in earnings (PMIs, Consumer Confidence, M1 growth). In addition margins and ROE – which are still far below peak in Europe – are linked to improvements in economic growth.
* Accounting for earnings catch-up, valuation is not stretched
The Shiller P/E (price divided by 10-year average EPS) for Europe is still around its long-term average; whereas in the US it is far above trend. Moreover, in Europe the 10-year average EPS is itself very low. Far from being an overly generous measure of valuation for Europe which assumes some return to pre-crisis trend earnings (one many investors including ourselves doubt), we believe the EPS it’s based on is fairly depressed with potential to improve as economies recover.
* Euro area, and especially the periphery, offer most upside
Our economists have upgraded their estimates for 2016 Euro-area GDP growth to 1.9% driven by improvements in the periphery. The unresolved debt problems in Greece are clearly weighing on performance in recent weeks, but it is here we see the most value with the cyclically-adjusted or Shiller P/Es for Italy and Spain remaining especially low.