Forget QE. Eurozone has a bigger problem to deal with

And obvisouly, the equity market doesn’t seem to care (although that’s partly true). From SocGen’s quant team (one of the greatest read coming from a broker).

As shown in a report published today, SocGen reminds us that Eurozone equities have been a very nice performer over the last 30 months and « trade on an aggregate at P/E premium to the rest of Europe and the rest of the world ». The question they ask therefore is: « Where is the equity upside, if any, from ECB QE? »

First off, the rebound in EZ equity market has 2 reasons: the level of equity indices after the market crash of 2008-2009 and then after July 2012, the main driver of EZ equity rebound was of course multiple expansion, or, its equivalent, market risk premium compression.

But while equity markets were attracting capital inflows, EPS weren’t growing. And that’s still the case.

Early 2014, investors were expecting a rebound in EPS growth, which did not happen until probably end of year – explaining the lackluster performance of Stoxx 600 (c. +4% when S&P 500 was up +11-12%, thanks in great part to share buybacks).

SocGen’s quant team estimates the P/E of EZ equity market is close to 18.7x today (I guess based on historical EPS not forecasted EPS). And investors still consider that EZ equities are cheaper than US equities. But the problem is deeper than thought, base mainly on which sectors will be responsible for EPS growth. And investors must pay close attention to what SG’s quant analysts write:

« To then trust in Eurozone equity market ‘cheapness’, investors have to buy into the principle that current earnings will revert to trend. As such, understanding which sectors are responsible for depressing current reported profits is also important. The ability of these sectors to bounce back is key to driving headline earnings in the region. What we find and show below is that these sectors are not cyclical; indeed with the global exception of commodities these sectors are internally focused and for a large part heavily regulated and suffering from significant structural changes. Return to trend in these sectors may well occur over the long run, but their earnings and cash flows are unlikely to be influenced materially by ECB QE, etc. », they write in their report.

Source: SG Cross Asset Research/Equity Quant

Source: SG Cross Asset Research/Equity Quant

Investors might find some opportunities though:

« Where we think there may be pockets of value in the Eurozone is in the small caps space. Driving this view is the simple notion that when we look at current share prices versus their 10 year average, the smallest Eurozone equities are still trading below their 10 year average share prices. Now obviously if a share price falls the smaller you become, but the same is true of Japanese and US small caps which are nonetheless trading well above their 10-year average share prices. So from our perspective, that there are still plenty of depressed share prices amongst the small caps in the Eurozone is in itself a reason to investigate further. »

The lag of European small & midcaps compared to the rest of the world is basically due to lackluster economic growth in EZ…

The big problem of EZ equity is one of lack of profitability & return on equity. From SG, the « equal-weighted return on equity of Eurozone equities is 400bp below that of the US and the rest of Europe. The ECB can print as much money as it wants, that won’t help much.

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