Euro area equity markets and shifting expectations for an economic recovery

Prepared by Miguel Ampudia, Daniel Kapp, Kristian Kristiansen and Cornelius Nicolay

Published as part of the ECB Economic Bulletin, Issue 5/2020.

Recent developments in equity prices and earnings growth expectations

As a result of the expected economic fallout from the global spread of the coronavirus (COVID-19) and the considerable associated uncertainty, euro area equity prices fell by more than 30% from February to mid-March 2020 (see Chart A). At the same time, liquidity conditions worsened significantly, as reflected in a pronounced widening of bid-ask spreads – a development which was not confined to equity markets.

With the announcement of the pandemic emergency purchase programme (PEPP), euro area equity prices started to recover (see Chart A) and market functioning has moved closer to normal levels, with bid-ask spreads decreasing sharply. Equity prices, especially those of US non-financial corporations (NFCs), also improved considerably, buoyed by the measures taken by central banks and governments in many countries. The recovery in equity prices looks even stronger when judged against the historical distribution of forward-looking valuation metrics (see Chart B). Owing to adjustments in near‑term earnings expectations and a near normalisation in equity risk premia, forward price‑earnings ratios (P/E ratios) for NFCs have now moved above pre-COVID-19 levels. While this is also the case for euro area banks, their valuations remain more subdued. However, in the light of the recent rapid adjustments in earnings expectations, the information value of price‑earnings measures should be taken with caution.

The main reason for the rebound in equity prices is a recovery in risk sentiment which, based on a decomposition using a dividend discount model, seems to have more than compensated for the declines in earnings expectations (see Chart C). Between early February and mid-March 2020 the euro area equity risk premium (ERP) increased from 8% to 12%, before decreasing to below 9% after the PEPP announcement. Although there is some uncertainty surrounding the estimation of the ERP, according to a dividend discount model, the fluctuations in the ERP explain both the lion’s share of the initial decline in equity prices and most of the subsequent recovery. At the same time, analysts’ earnings expectations have been adjusted downwards. In the wake of the lockdown measures implemented across euro area countries, shorter-term earnings growth expectations turned negative for the first time since 2009, but they appear to have troughed recently as the economic recovery is expected to gradually take hold. By contrast, until mid-April 2020 analysts’ longer-term earnings expectations remained surprisingly resilient, in line with prospects of a strong and rapid recovery in earnings (see Chart D). More recently, they have been adjusted downwards by more than 3 percentage points to below 8% per annum. Despite this drop, longer-term earnings expectations remain higher than at the low point of the global financial crisis.

Equity prices and short versus longer-term revisions to the macro outlook

In the light of the ongoing gradual downward adjustment of longer-term earnings prospects, the recovery in short-term earnings prospects has been an important counterbalance. Equity prices reflect the discounted value of all future dividend streams, where the weight of dividends in the near term depends on the investor’s discount factor (including the required ERP). Therefore, the (initial) resilience of longer-term earnings prospects (more than one year ahead) and the recent recovery in short-term earnings prospects (i.e. over the next year) could explain some of the relative robustness of and recent recovery in equity prices. Results of a regression analysis which makes use of past Consensus Economics forecast vintages to assess the impact of past changes in GDP growth expectations on equity prices at different horizons suggest that investors tend to attach equal weight to short-term forecasts and longer-term expectations when evaluating the market implications of macroeconomic developments. Overall, the risk of significant further declines in equity prices still remains, especially if long-term GDP growth expectations are adjusted down further or the recent upward revisions to the near‑term outlook decline again (as a result of a potential second wave of the coronavirus and consequent policy responses, for example).

Signals about the shape of the recovery derived from earnings per share forecasts, dividends and options

In addition to analysts’ longer-term earnings growth expectations, earnings per share (EPS) forecasts also continue to be revised down at longer horizons (see Chart E). In mid-March 2020 the pattern of surveyed quarterly earnings forecasts continued to largely signal a V-shaped recovery, despite weak realised earnings in the first quarter of 2020. Analysts foresaw a rapid recovery from the second quarter onwards as economies were expected to gradually emerge from lockdown. Since then, notwithstanding the announcement of the PEPP, the general level of medium-term earnings expectations has continued to be revised downwards, even though euro area stock prices recovered over the same period.

The assessment of the future outlook appears even less sanguine when judged on the basis of futures pricing rather than surveys (see panel (a) of Chart F). The term structure of claims on future dividend payments, known as dividend strips, shows that markets expect dividends to lie far below pre-COVID-19 levels in the near future. Although dividend futures prices with maturities of more than two years are slightly higher than before the PEPP announcement, they remain well below the prices observed prior to the global spread of COVID-19.

In addition, risks of renewed price corrections in the near future continue to be seen as likely, as indicated by the term structure of the equity risk premium (see panel (b) of Chart F). Estimating the ERP from options prices at horizons between 1 and 24 months shows that the term structure of the ERP is likely to be upward sloping during normal times, as was (marginally) the case in February 2020, for instance, and downward sloping in times of financial stress, caused by the risk of large potential losses in the near future. In line with this conjecture, and immediately before the announcement of the PEPP, the ERP at the one-month horizon surged to around 30%. Despite a significant decline since then, the ERP still remains well above the levels seen in February at all horizons and the term structure slope continues to be inverted.

Other option-based measures of uncertainty also continue to stand at heightened levels and left tail risk remains very elevated (see Chart G). The risk-neutral distribution of expected returns by investors can be extracted from options prices.^[1] Since options contracts with different maturities are traded at any point in time, it is possible to derive a term structure of the investors’ risk-neutral distribution of expected returns. Between February and late March 2020 there was a substantial reduction of left tail risk (“bad risk”) relative to right tail risk (“good risk”), as implied by the reduction in the skewness coefficient of the Euro Stoxx 50 risk‑neutral density derived from options prices (see left-hand panel of Chart G).^[2] Already in early February, before the outbreak of the COVID-19 pandemic in Europe, options markets signalled a large imbalance of left tail risk two to three months ahead, with a reduction afterwards. Following the equity market correction, the implied left tail risk and right tail risk became more balanced for the months ahead. This was the result of investors starting to attach more weight to the possibility of a further price recovery (i.e. increasing the odds of good risk versus bad risk) and was in line with a decline in the ERP since the height of the pandemic. However, owing to the recent cascade of negative economic news and fears of a new virus wave, the risk-neutral distribution remained highly skewed to the left when compared with historical episodes (see right-hand panel of Chart G). Moreover, uncertainty as indicated by the variance of the distributions is still elevated.