We remain constructive on European equities and upgrade our long-term return targets to end- 2016. The main driver of this is a larger expected decline in the equity risk premium, resulting in a higher P/E multiple. However, equities are more vulnerable to drawdowns due to a smaller valuation cushion and geopolitical risks. To gain strategic equity exposure but limit downside risks, investors could buy call options, with prices looking attractive in Europe due to lower implied volatility and very low forward prices.
* Upgrading our long-term return targets due to lower cost of equity
We expect a continued and now larger decline in the equity risk premium to the end of 2016, feeding through to a lower cost of equity and therefore a higher P/E multiple. Our new forecasts for STOXX 600 are 410 and 450 for end-2015 and 2016 respectively (compared to 380 and 400 previously).
* Risk of a drawdown has increased
While we remain constructive on equities, we believe the risk of a drawdown has increased as the valuation cushion is now smaller. Our risk model based on the level of valuation and volatility suggests a 21% probability of ma 10% drawdown. Also, geopolitical risks might increase.
* Long-dated call option prices look low in Europe
To gain strategic exposure to equities while limiting downside risks, investors can buy long-dated call options. Those look attractive in Europe currently due to relatively low implied volatility and very low forward prices. This also presents an opportunity to re-risk in equities for capitalconstrained investors such as pension funds and insurance companies.