Speaking at a dinner on Tuesday 22nd January Bank of England governor Mr Mervyn King indicated that, in the view of the Bank, the turmoil consuming the financial markets over the past couple of months represents a step towards the inevitable, and long overdue, re-pricing of risk assets and is, in his words, “A process that we should (not) try and reverse”.
Although we are dismayed that the only central bank that appears to have woken up to the long-term threat to prosperity caused by global credit contagion is the US Federal Reserve, we do believe that scope exists for even the ultra-risk averse Bank of England (and European Central Bank) to participate, at least partially, in the process of developed economy monetary easing. We got thinking in the wake of Mr King’s comment regarding the extent to which equities are currently pricing in recessionary conditions.
Our conclusion indicates that certain specific sectors are already trading at levels commensurate with a marked deterioration in economic activity. These include (as one might expect) the banks, insurers and asset managers, in addition to the media, house builders, real estate and technology sectors. Should a bear market rally get underway through the results season, aggressive investors might attempt to take advantage of knockdown ratings in an attempt to mitigate falling portfolio values.
2008 earnings forecasts
At least part of the recent equity market set-back can be ascribed to concern regarding the durability of 2008 earnings forecasts which had, remarkably, remained intact over the latter part of 2007. Looking at the picture from a top down perspective we believe that European (including UK) equities are currently working off an implied equity risk premium of 4.0%, very similar, in fact, to the level reached in March 2003, the point immediately prior to the second invasion of Iraq at which equity markets troughed before embarking on their prolonged bull run.
The difference now is that 2008 forecast earnings look very vulnerable to downgrades. The combination of an ERP of 4.0% and a fall in earnings (of c5%) which seems very possible to us, indicates that European equities have a further 5% potential downside from recent base levels.
Factor in a more aggressive decline in earnings (i.e. back to long-term trend) of c20% and equities have the capacity to fall by an additional 20% in our view. In fact we regard this latter scenario as unlikely as the positive impact of globalisation (increased productivity, lower inflation and real interest rates) indicate that the earnings should trough at a higher level than that recorded in the past. Furthermore, an earnings adjustment would be unlikely to take place in one year alone, thus mitigating the potential downside impact.
In terms of absolute valuations, the prospective price earnings ratio on the MSCI Europe Index stands at 11.9 for 2008 and 10.8 for 2009, a contraction in the order of 20% over the past six months and not far off its lowest level recorded in over a decade. As we have highlighted before, these multiples do require an act of faith on investors’ part, based as they are on peak earnings and margins, not through the cycle earnings as we continue to advocate makes more sense. Critically, stated multiples are based on estimated consensus earnings growth of 10.2% over 2008. If earnings were to grow by 7.5% the multiple would rise, all things being equal, to 11.1 and equities would, again, need to fall by around 20% for the multiple to get back to trough levels. Significantly though, interest rates and inflation levels were very much higher than is currently the case so, again, we suspect that the order of magnitude of any potential fall from here is likely to be more limited.
Backing up what we have been saying elsewhere, it is notable that despite falling into bear market territory, medium sized and smaller companies still exhibit the capacity to fall by a further 15% and 20% respectively to trough valuations. We retain our marked preference for large capitalisation stocks given their greater geographical diversity and suspect that continued risk aversion on the part of investors generally should ensure that interest in the mid and small cap segments remains limited for now. On this basis further downside away from the FTSE 100 is distinctly possible once the latest bout of short-covering works its way through the system.
Which sectors are already priced for recession?
Turning to specific sector analysis we note marked disparity between those sectors already priced for recession and those which are not. Unsurprisingly, given the travails of the financial sector, all components (banks, insurers, real estate and asset managers) are now fully pricing in a recession. Given their heavy weighting in the UK All Share it is arguable that the UK equity market is approximately 80% priced for recession already. Other heavyweight sectors such as Oil & Gas and Telecoms are, we estimate, between 55% and 65% priced for recession.
By contrast and despite marked weakness in absolute terms, consumer facing and cyclical sectors are still not there yet. Retail is approximately 60% rated for recession while Industrials have only about 25% priced in. Sectors which are not rated for recession at all include Personal Goods, Utilities and Food Producers. The one outlier in all this is Pharmaceuticals. On pure rating grounds the sector is only 25% of the way to recession territory, however, current multiples are back to multi-year lows a reflection of the fact that the structural problems besetting the industry are already being factored in to share prices.
What is interesting about this is that if a recession does not manifest itself and what materialises is, instead, another mid-cycle correction, investor interest is likely to focus on those sectors regarded as most bombed out in the wake of sharp equity market corrections. Although the market’s bounce on Thursday proved spectacular it was pretty indiscriminate. When the dust settles short-term investors looking to take advantage of what still looks like a bear market rally will probably alight on those as offering the best scope for short-term gains.
How long the rally lasts will, however, depend on more detailed analysis pertaining to the point at which the macro economic environment is likely to trough. At present Q2 / Q3 2007 seems the consensus expectation. We believe that there are risks to this view, just as we are concerned regarding the ultimate strength and nature of the eventual recovery. However, equity investors, seeking crumbs of comfort and scenting that the worst might be over, will need few incentives to pile back in.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley