According to a February 2nd report from Morgan Stanley Equity Research, European stock markets are likely to enjoy a strong run in 2015. Morgan Stanley analysts Sebastian Raedler and colleagues argue that improving macroeconomic conditions, the ECB’s ramping up of QE and the unwinding of the current “risk premium” means European stocks are set for a banner year in 2015.

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European Stocks

Why European equities are the place to be

European Stocks

Easing financial conditions — Raedler et al. note that the price of oil has fallen by 55% over the last six months, the euro is down by 15% and German 10-year bond yields are also off 80 basis points. They argue taken as a whole “This constitutes the most significant easing of financial conditions in the Euro area since at least the set-up of the common currency area in 1999.”

European Stocks

Boost from eurozone QE program — The MS analysts also note that while the Fed has completed its asset purchase program, the ECB is just kicking off its own €1 trillion QE program. They say that while investors are clearly excited about the ECB’s QE announcement, they believe all the ways in which monetary easing helps European stocks are not well understood or baked into prices.

European Stocks

Lower bond yields — Another important consideration is that ECB monetary easing has pushed corporate investment grade corporate bond yields in Europe to an all-time low of 1.2%, and also to a seven-year low compared to U.S. corporate bond yields (currently yielding 2.75%). The drop in the interest expense relating to decreasing corporate bond yields between 2009 and 2013 in the U.S. helped push margins to a 60-year high. The benefit from lower borrowing costs are only now starting to show up in Europe, and should improve European earnings by a minimum of 2% this year.

European Stocks

Furthermore, given German 10-year bonds are yielding 0.3%, European IG corporate debt 1.2% and U.S. equities only offering a yield of 2%, there is more than a little incentive for investors seeking income to jump on  the 3.2% dividend yield to be found in the European equity market.

Morgan Stanley recommended European stocks

The Morgan Stanley report also recommends a number of European stocks. “We highlight European companies that our analysts believe offer a strong franchise and attractive valuations relative to global peers. Of these, BMW, IAG, RyanAir, Deutsche Post, Eurotunnel, Publicis, Philips, IHG, AXA, Prudential and UBS are OW-rated by our analysts and are in sectors where we are overweight.”

Specifically, the analysts note:

European equities are still trading on a 16% P/B discount to global markets, with the relative P/B close to the 20-year trough reached in 2012 (when they were at an 18% discount). Similarly, the European ERP, at 7.9%, is around 290bps above that in the US – even though the best predictor of the ERP gap, the spread between US and German bond yields, would point to a warranted ERP gap of only around 200bps. This means that there is currently an “excess” equity risk premium of around 90bps priced into European equities that is not explained by the macro differences between the US and Europe, which are already priced into the bond market.

European Stocks