Eurozone equity risk premium much higher than US
The extra return that investors are demanding to buy Eurozone shares instead of US shares is the highest it has been since 2012.
The cost of equity, or the minimum return that investors require to buy a share, is 80 basis points above that of the US where it has been on a multi-year declining trend driven by lower treasury yields and a stable equity risk premium. In addition in the US, the return on equity has been consistently higher than the Eurozone for most of the last two decades making the US the preferred region to invest.
Our analysis shows that while monetary easing has boosted the Eurozone’s bond markets through lower credit spreads, the follow-through into lower equity risk premiums has been less successful.
The Eurozone equity risk premium is still at 6.5%, which is the highest level since the global financial crisis in 2009 or the Eurozone crisis in 2011.
Flaws in the institutional framework, a burdened banking sector, political uncertainty and Brexit explain the reluctance of investors to buy Eurozone equities. On top of that, Eurozone earnings growth has lagged US earnings growth with the exception of 2015.
Is a turnaround in the relative fortunes of the Eurozone possible? It comes down to a couple of factors. The first one is creating higher nominal GDP growth which facilitates a company to increase its margins and return on equity. More fiscal and monetary policy coordination including, for example, infrastructure, could be a way. With elections in France, Germany and the Netherlands next year and after the Brexit outcome, the willingness to counter anti-Europe populism may have increased.
Second, US profit margins could come under pressure from rising wages given the trends in the labour market.
Finally, a US rate hike could push the cost of equity higher or pressure the net profit margin. So, there are several potential factors we can think of but it may take some time for these to come into play.
Patrick Moonen, principal strategist, Multi Asset at NN Investment Partners