Equities fall as ECB liquidity shot wears off The European Central Bank's "monetary morphine" appears to be wearing off. After more than €1tn of central bank money soothed nerves over Greece's debt restructuring, European equity markets are once more falling, spooked by the eurozone periphery. While global markets have remained relatively buoyant, every major stock market in Europe has dipped markedly over the past month, with the exception of Switzerland. Spain and Italy have both shed around 10 per cent. "It doesn't seem like the ECB's money has solved much," says Richard Cookson, chief investment officer at Citi Private Bank. "It all feels uncannily similar to last year," when markets started strongly, but suffered a torrid second half. Rather than Greece, it is Spain that is now the centre of investors" concerns. The Spanish stock market missed the first quarter rally, and has continued its poor run in April, as fund managers take fright at its daunting fiscal and economic challenges. A few more poor days of trading downwards and it will plumb its post-Lehman lows. "We'll start to see the impact of austerity soon, and it won't be pretty," says Sam Morse, a fund manager at Fidelity. I think the impact could be even worse than feared. Italy has come under pressure, too. As in Spain, banks have led the decline, as investors expressed fears over their increasing sovereign exposure. Spanish and Italian banks increased purchases of their governments" debts this year, funded by money from the ECB's longer term refinancing operations. This sent government bond yields, which move inversely to prices, tumbling from their euro-era highs, but increased their exposure to their sovereign debt. Yields on Spanish and Italian debt are now rising again. "There's a symbiotic relationship between European banks and governments, so weaker bonds mean weaker banks, and weaker banks mean weaker bonds," Mr Cookson says. The stock markets of "core" Europe have fared better, particularly Germany's Dax index, this year's outstanding performer with a 15 per cent gain. Germany "is a free-rider on the economic troubles of its euro-sharing neighbours, with negative real-interest rates" and a weaker currency than its economy warrants, BNP Paribas analysts said in a note this week, upgrading the Dax to overweight. Yet even Germany's ebullient stock market remains susceptible to renewed concerns over the eurozone crisis. Moreover, many German companies are large exporters, and as such are exposed to a slowdown in growth in emerging markets such as China. Indeed, the Dax last week pared this year's rally. Investors in European equity funds certainly seem to be nervous still. Despite the rally, almost $8bn was pulled out of western European equity funds in the first quarter of the year, according to EPFR Global, a data provider, following a $17.2bn withdrawal in 2011, much of that in a dismal second half. Nonetheless, most fund managers remain cautiously positive towards European stock markets as a whole. While the systemic risks of last year have not gone away, they have faded thanks to the LTRO. Investors argue the recent stock market retreat is not unexpected after a mostly buoyant first quarter. "This is a pause for breath," says Nigel Bolton, head of European equities at BlackRock, the US asset manager. The peak of the LTRO effect has passed, but this is more of a settling in period than a return to last year's turmoil. Even after the rally, fund managers and analysts say valuations are still compelling. The Eurofirst 300 index, for example, is trading at 9.6 times the estimated 2012 earnings, well below the historical norm, and with a generous dividend yield of about 5 per cent. While Europe's economy may be far from recovery, the evidence of links between growth and stock market returns is weak, fund managers argue. Mr Bolton estimates that about 53 per cent of the earnings of European companies come from outside the continent, and will counteract any domestic weakness. European stock market valuations look particularly attractive compared to other major markets. The difference between the cyclically adjusted price to earnings ratio of the US and Europe has only been higher in five years over the past century, Mr Cookson points out. There are signs investors have become more discerning. In the first quarter the riskier assets that were the most beaten up last year benefited most from improving sentiment. Some fund managers say that over the next few months they are likely to prefer more defensive stocks. "High risk offers high excitement, not high returns, because excitement is overvalued," Dylan Grice, a global strategist at Société Générale, argued in a recent note. "Quality names are boring, and "boring" is undervalued." Despite the nervousness over European financial contagion, even Italian and Spanish equities are still attracting buyers. "We've had a nice run in Europe, and I suspect we'll have our usual summer wobble, but with the longer view in mind there are still some bargains to pick up," Mr Morse says. "We don't stop looking at these supposedly "uninvestible" companies and countries. When people start saying something is uninvestible, there's often value there.