European stocks may surge 50 percent in the next two to three years as investors switch to shares from bonds amid higher risk premiums and record-low interest rates, a Credit Suisse Group AG global strategist said.
About $22 billion moved into equity funds around the world in the week ended Jan. 9, the second-biggest inflow on record, according to data going back to 1996, compiled by EPFR Global, a subsidiary of Informa Plc. Equity funds lured $200 million more inflows than bonds as of Jan. 16, the sixth consecutive week of more inflows, Citigroup Inc. wrote in a report on Jan. 18.
“We see extreme potential for European equities, even if they come back down temporarily,” Hong-Kong based Adrian Zuercher said in an interview in Zurich. “We’ve seen record inflows into equities in the first week of the year. That points to a risk-on mode that is so high that investors are willing to buy stocks amid higher volatility, as they expect to get compensated for the risk they take.”
The benchmark Stoxx Europe 600 Index rallied 3.1 percent through Jan. 23 as U.S. lawmakers reached a compromise to prevent more than $600 billion of tax increases and spending cuts that may have pushed the world’s largest economy into a recession, and companies reported better-than-expected earnings.
“We have extremely high risk premiums for equities,” Zuercher said. “They are so high that one can make a long-term, structural case. After years of outflows from equity markets and big disinterest and distrust, seeing the first signs of so much money coming in is positive. We would only see corrections as a chance to enter a cheaper market.”
The difference between the earnings yield on Stoxx 600 equities and rates on German 10-year bunds -- known as the equity risk premium -- was 3.63 percentage points as of Jan 23. The index’s valuation is at 12.1 times estimated earnings, compared with 13.5 times for the Standard & Poor’s 500 Index.
“Stock markets, compared with bond markets, are extremely cheap,” Zuercher said. “Investors learned to live with their ‘volaphobia’ last year even amid high political uncertainty. We don’t have that as much this year; in addition, we have the infrastructure on the monetary side that not only calmed market participants, but forced them to take risk. Even with higher inflation numbers, central banks may want to keep interest rates low due to debt levels.”
The European Central Bank’s benchmark rate stands at a record low of 0.75 percent.
“Bonds are uninteresting because of their negative real yield,” Zuercher said. “We don’t expect a trend turn in 2013, but we may see it in the next two to three years. Rates will remain low, but the performance driver is gone.”
The U.K. 10-year inflation-linked yield tumbled to a record-low minus 0.99 percent on Jan. 10. A negative yield means investors buying the securities will receive payments below the retail price index if they are held to maturity.
Credit Suisse raised its holdings of European equities to overweight from neutral in June, saying they were undervalued and would probably rally. In October, Switzerland’s second-largest lender said it would buy equities whenever they fell temporarily.
“It looks like it doesn’t take much for investors to buy stocks, when only a few months ago the opposite was true,” Zuercher said. “Many people are still on the sidelines and too defensive. They’re just waiting for a little correction. We see big potential for stock markets.”