Equity markets have enjoyed a strong revival over the six week period following perceived capitulation on 17th March. A recovery was always likely as the Federal Reserve and Bank of England paved the way for the partial relief of banks’ over-stretched balance sheets.
Whilst investors are likely to be both pleased and relieved at the extent to which risk appetite appears to have recovered, the continuing difficulties being experienced by the Western banking sector, inter-twined with an economic slow-down that is now well underway, do not enable us to feel entirely confident that we’re out of the woods yet.
The lopsided “W”
History, according to Mark Twain, does not repeat itself exactly, but it does rhyme. For this reason we believe it instructive to look at previous occasions over the past forty years in which a period of pronounced equity market weakness has been followed by a partial rebound…and then to look at what happened next.
Since 1970 there have been three periods of pronounced and prolonged equity market weakness in Europe; January 1973 to September 1981, July 1990 to August 1992 and September 2000 to March 2003. On each occasion the low point for equities occurred some time after the bear market formally began, following which a partial, but shortlived, rally occurred. This then petered out with momentum only returning some time later.
In the current period the following has occurred:
Whilst the above indicates that a pull-back from prevailing levels would be far from setting a precedent why do we believe that investors should remain vigilant now? The basis of our position lies in our belief that, contrary to what the Bank of England’s latest Financial Stability report might have us think, we do not believe that the credit crunch has run its course. As part of the central banks’ promise to bail out the beleaguered banks, the US Federal Reserve has added asset-backed securities to the list of acceptable collateral it is prepared to take on board.
Far from a sign of strength and a willingness on the part of the Fed to “do whatever it takes” we view this move as endorsing the likelihood that the banks will throw every potentially risky loan into the melting pot including credit card and student loans (the latter the subject of a recent address by the President). In turn this seriously reduces the quality of the Federal Reserve’s own balance sheet and hardly induces the sense that activities between the banks are freeing up at all.
Indeed, quite the opposite. The Fed is accepting these loans purely in response to the fact that the banks are still experiencing difficulties in securitising these loans themselves. Unless these loans can be securitised they must revert to banks’ balance sheets and at the present time no bank is sufficiently strong to withstand the adverse impact on its capital position in such an eventuality. In such circumstances we do not believe that the return of enthusiasm has much underpinning in macro-economic reality.
Profits under pressure
This sense that the foundations for the equity market’s rally may be built on sand is reinforced by events in the real economy which have confirmed that a pronounced slow-down is underway. Whilst “bottom-up” sector and stock analysts have been lowering their expectations for earnings growth, the process has further to go in our view.
Consensus earnings across Europe are now expected to grow by just 4.5% in 2008, compared with expectations for c10% growth at the start of the year. In the UK, the FTSE 100 is expected to show aggregate earnings growth of 5.2% this year and the Mid-250 4.8%.
The problem is that in an environment in which future access to credit for companies and individuals alike is likely to be severely constrained, the timing, extent and strength of the eventual economic recovery is very much in question.
Whilst sector and stock analysts have lowered earnings expectations for 2008, 2009 forecasts remain intact. This implies that pan-European earnings are expected to grow by 11.9% next year, while the FTSE 100 is expected to enjoy earnings growth of 9.6% and the Mid-250 of 11.0%. This implies all these benchmark indices trading off c10.5x next year, a level given the prevailing economic outlook, which looks more than somewhat fanciful.
The major saving grace for the UK equity market is, as we mentioned last week, the explicit reduction in the defensive nature of the composition of benchmark indices given that Energy and Basic Materials companies now account for some 30% of the overall index by market capitalisation.
Given our feeling that the dollar is expected to continue to weaken on the foreign exchanges (although perhaps not against sterling), we suspect that energy and raw material prices will continue to rise on world markets. In such circumstances it is worth pointing out that the only two global sectors to enjoy meaningful earnings upgrades over April were indeed energy and basic resources.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley