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Progress on policy front could reduce European equity risk premium

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While investor fears of systemic risk in Europe continue to weigh on European equities, Invesco Perpetual’s European equity team in Henley-on-Thames, UK, believes that the recent ECB governing council meeting might just prove to have been a credible step in reducing some of the tail risks in Europe.

The ECB has indicated its willingness to provide significant financial support to any country which requests assistance, acting alongside the European Financial Stability Mechanism/European Stability Mechanism.

This could help to reduce equity risk premiums for European equities which currently remain extremely elevated relative both to their historic levels and the US market.

In the Monthly Summary issued in August 2012, Joel Copp-Barton, European product director at Invesco Perpetual, highlights what the team believe to be attractive opportunities for stock pickers in shunned geographical markets and unloved sectors of industry.
 
“Investors have tended to put certainty and low risk at the heart of their investment strategies in recent times, with other areas largely ignored,” Copp-Barton notes. “We would argue that depressed valuations already assume a challenging macro environment going forward. More confidence in the ECB and the key policymakers could be supportive generally for European equities, but we believe that some areas of the market have been even more de-rated than the European market as a whole.”
 
Although much of the detail still needs to be worked through, policymakers’ recent actions are putting in place a framework for addressing the high level of sovereign spreads in peripheral Europe. According to Copp-Barton, this should provide peripheral governments with time for the structural reforms and fiscal consolidation to make the required progress, with many of these programmes already in place in Spain and Italy.

Copp-Barton is optimistic that “the reform agendas have the necessary teeth to increase competitiveness and productivity,” particularly as the latest ECB proposals build on other recent actions, such as the proposed recapitalisation of the Spanish banking system and the central bank’s decision to cut the deposit rate to zero.
 
In combination, these actions could help reduce systemic risk in the eurozone and the high current equity risk premiums.

“Reducing the associated tail risks could see investors start to concentrate on stock fundamentals again as opposed to the political environment,” Copp-Barton says. “A greater focus on stock picking by the investment community could help to highlight and close the gap between current share prices and their intrinsic value, even more so for some of the neglected areas of the market.”

According to his team’s analysis, these include autos, pharmaceuticals and insurance, in particular, which are trading at a significant discount to their long-term averages, as well as companies that have been unjustly punished for being domiciled in peripheral nations.

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