Eurozone Overweight Supported By Risk Premium

Eurozone equity risk premiumEurozone equity risk premium

A decent rebound in eurozone equities in recent weeks brought up concerns that the market might already be overvalued by now. First of all, Julius Baer’s research want to clarify that “valuation is not the main driver of our asset allocation as earnings definitively remain more important”. However, valuation is easy to observe and thus attracts quite some attention. One of the measures they are following is the equity risk premium. While there are several possibilities to calculate this, the firm uses the difference between earnings yield and bond yield. An elevated level of the equity risk premium indicates that equity investors are compensated for taking a higher risk. As reported by Christoph Riniker, Head Equity Strategy Research:

Comparing the equity risk premium of the US market with the one of the eurozone shows that the US is well below its long-term average (at 3.5% vs. the 4.3% average) while we see a eurozone risk premium of 5.3% that is almost on the average (5.6%). The eurozone therefore looks more attractive. However, it is even more interesting to find out about the potential future price/earnings (P/E) level of the equity market. For that we have to assume that the equity risk premium will revert to the mean over the next 12 months.

Furthermore they use the Julius Baer bond yield forecast of 2.5% for US 10-year government bonds and 0.7% for the eurozone counterpart.

Taking all this into consideration, US equities should trade at 14.7x as opposed to the current level of 17.3x. On the other hand, eurozone equities could even further revalue as they deserve a P/E of 15.9x rather than the current level of 14.8x. In our index models, we use valuation levels near current levels given the minor importance compared to earnings. The relative attractiveness of eurozone equities still remains in place.