European stock market "shift": Will the dramatic change in fiscal policy drive valuation reshaping?

"At All Costs" 2.0, European stock markets welcome a structural revaluation opportunity.

On March 20, Citigroup published a research report stating that the recent significant policy shift in Europe will change the economic trajectory of the region, particularly with a substantial increase in defense and infrastructure spending, which may also bring valuation revaluation opportunities for European stock markets.

Citigroup analysts believe that European stock markets have underperformed for a long time after the global financial crisis, mainly due to low growth, low interest rates, and low inflation environments. Many investors view European stock markets as "short-term trades" rather than markets with long-term growth potential. However, there has been a fundamental shift in policy recently:

• Significant increase in defense spending: The EU is providing €150 billion in defense financing loans, and EU fiscal rules will be adjusted to allow for an increase of €650 billion in defense spending over the next four years. European defense spending is expected to rise from the current 1.9% of GDP to 3% by the end of this decade.
• €500 billion infrastructure investment in Germany: Germany has launched a €500 billion infrastructure fund, which will be spent over the next decade, equivalent to an incremental expenditure of about 1% of GDP per year.

The Citigroup report points out that while the full economic effects may not become more apparent until after 2027, European stock markets still face risks such as U.S. tariffs and economic slowdown in the short term. However, the shift in European policy provides a long-term sustained upward momentum for the stock market and will also change investors' long-standing view of Europe as merely a "trading opportunity." Therefore, under an optimistic yet reasonable scenario, stimulating policies are expected to drive the forward PE of the stock market from 14 times to 16 times by December, achieving a 10-15% valuation revaluation.

This revaluation is primarily achieved through two major driving factors: higher long-term earnings per share growth expectations and lower equity risk premiums.

Higher Long-Term Earnings Per Share Growth

According to Citigroup research, the first driving factor for higher valuations is higher growth.

Higher free cash flow resulting from increased earnings per share (EPS) growth can justify higher valuations, and recent stimulus measures provide new support for EPS growth. Citigroup expects:

• European defense spending will contribute an additional 2% annual growth to the EPS of the STOXX Europe 600 index;
• The German stimulus plan will further contribute 1%, which could lead to an approximately 20% increase in EPS by 2029.

Citigroup's analysis shows that for every 1% increase in EPS growth rate, it is typically associated with an increase of about 0.5 times in the 12-month forward price-to-earnings ratio. Therefore, a 3% increase in EPS growth rate could lead to approximately 1.5 times revaluation of the price-to-earnings ratio

Lower Equity Risk Premium

Citigroup pointed out that the lower equity risk premium (ERP) is the second driving factor for revaluation.

Citigroup's model shows that European stock markets, as a cyclical market, typically have an equity risk premium (ERP) that is higher than the overall level of developed markets. Generally, the pan-European ERP is about 4%, while the overall MSCI developed markets is slightly below 3%.

During periods of economic growth and stability, the ERP tends to contract. From 2003 to 2007, the long-term growth rate was 1% higher than it is now, and correspondingly, the average pan-European ERP during this period was about 25 basis points lower than the latest estimate.

Citigroup believes that in an optimistic scenario, the ERP could decrease by 25 basis points, which would increase the 12-month forward price-to-earnings ratio by about 0.5 times. Although the valuation revaluation process may take time and face stock market volatility, the shift in the European market narrative may provide more structural upward support