HOUSE_OVERSIGHT_014468.jpg

Chart 17: MSCI Europe forward PE in-line with 30-year average at 14.1x...
30
25
20
15
10
5
12/87 12/91 12/95 12/99 12/03 12/07 12/11 12/15
— MSCI Europe PE 12m fwd
Source: BofA Merrill Lynch Global Research, Datastream, IBES

Chart 18: ...but at lower end of 13-15.5x PE range of last 15 months
17.0
16.0
15.0
14.0
13.0
12.0
01/14 07/14 01/15 07/15 01/16 07/16
— MSCI Europe PE 12m fwd
Source: BofA Merrill Lynch Global Research, Datastream, IBES

Relative attractiveness of Europe depends on EPS recovery in medium-term.
Moving to relative valuations, European equities screen somewhat cheap vs their DM peers. However, the medium-term bull case for Europe is far more a function of potential earnings and ROE recovery rather than significant undervaluation. Europe’s valuation discount to the US is at multi decade wides on PBV (over 40%) but that in turn reflects Europe’s significant underperformance on EPS growth and ROE. Trailing ROE for MSCI Europe is just 8% (at historical trough levels). That is nearly 5pp below MSCI USA compared to a 3pp gap on average historically and close to the widest spreads since the mid-1990s.

Europe vs US relative PE 7% below average. Based on PE, Europe nevertheless trades cheap relative to the US. The PE discount at 18% is 7% wider than the 20 year average and relative PE is at the lowest level since 2012. So while a sustained reversal in the underperformance of Europe versus the US would over time have to be driven by a recovery in relative profitability we do see current valuations reflecting a discount perhaps for political reasons (Brexit, upcoming elections).

Chart 19: Europe vs US: modest PE discount but cheap on rel. PBV
1.10
1.00
0.90
0.80
0.70
0.60
0.50
06/96 06/99 06/02 06/05 06/08 06/11 06/14
— Relative PBV (MSCI)
— Relative PE (12m fwd, IBES)
Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES

Chart 20: European earnings and profitability significantly lag the US
20
18
16
14
12
10
8
6
06/96 06/99 06/02 06/05 06/08 06/11 06/14
— MSCI USA - trailing ROE
— MSCI Europe - trailing ROE
Source: BofA Merrill Lynch Global Research, Datastream, MSCI

The other metric that illustrates the valuation overhang in Europe is the risk premium. Our model calculates an implied cost of equity (CoE) for Europe as 6.8%, a little below the average since 1988 (7.2%) and last 10 years (8.4%). The model assumes the cost of equity is simply the cyclically adjusted earnings yield (calculated using a 5 year centred average EPS). We then compare this number to the German bund yield to estimate the implied equity risk premium (ERP).

Bank of America
Merrill Lynch
European Equity Strategy | 01 December 2016
9
HOUSE_OVERSIGHT_014468