Most markets finished up again last year, with the FTSE All-World index gaining 10% in dollar terms. But in 2008 profits “could prove as elusive as those notorious Revenue and Customs data CDs”, as Andrew Ellson puts it in The Times.
Rarely has the outlook been so fraught with potential trouble. Losses stemming from the subprime crisis have yet to work their way through the banking system and look set to rise now defaults are emerging on other classes of mortgages and credit cards.
Then there’s the broader danger of a US recession, which may be followed by a UK one; and can emerging economies really decouple from a sharp US slowdown? Amid all this uncertainty, here is a summary of perspectives on global markets this year.
Western Europe: the bull is faltering
Europe’s bull run lost steam in 2007, with the pan-European DJ Stoxx 600 index easing from a seven-year high to end the year down by 0.2%, though an index of the top 50 eurozone stocks eked out a 6.8% gain. Headwinds have gathered strength of late, with global and eurozone economic growth past their peak.
Merrill Lynch has pencilled in eurozone GDP growth of 2.1% for this year, down from 2.6% in 2007, noting that “Europe’s own back yard looks pretty robust” with budget deficits low and consumers having sat out the credit binge of the Anglo-Saxon countries. It sees scope for another 10% climb in the Stoxx 600 in 2008, but warns a US recession would undermine this forecast.
According to Eric Chaney, tightening credit conditions, the recent rise in the euro, the lagged effect of the oil-price spike and a mild US recession could wipe up to 1% off the eurozone in 2008. Given world trade as a proportion of GDP is at a 70-year high, the US malaise is likely to infect the rest of the world, says Morgan Stanley’s European strategist Teun Draaisma. European earnings per share look set to fall 1% in 2008, while the consensus expects growth of up to 10%.
Earnings upsets would dent markets’ apparently cheap valuations, says Wirtschaftswoche. Firms in Germany’s benchmark index are particularly exposed to the global economic cycle, which explains why the DAX did especially well in recent years, adds Boerse Online. But with margins at historic highs, export growth slowing and investment easing, 13% earnings growth looks unrealistic.
Still, the cloudy outlook doesn’t mean Europe has run out of money-making opportunities, says Hugh Cuthbert of the SVM Continental Europe fund, the sector’s third-best performer over the past three years. Telecoms, for instance, look cheap, and “what better than a sustained financial meltdown to highlight” rock solid balance sheets and dividends? Boerse Online also likes telecoms, highlighting Spain’s Telefonica (TEF), which is benefiting from fast growth in Latin America.
Don’t write off Japan
The Nikkei 225 index’s 11% drop last year was the worst performance of any major market. Investors have been rattled by the lacklustre domestic economy, which the government now expects to grow by 1.3% in the year to March 2008, downgrading its initial 2.1% estimate. Wages and consumption have been stagnant, while a fall in housing construction has also dented growth.
But the market is hardly a write-off. The collapse in residential investment was due to the botched introduction of a new building code, since relaxed; a recovery in the sector could add as much as 0.5% to GDP growth next year, says Capital Economics.
The widely watched quarterly Tankan survey of business conditions remains “well above recession territory”; manufacturers reported that overseas conditions had improved since September, suggesting weaker demand from the US is being offset by stronger demand elsewhere. The survey also pointed to a tighter labour market and capacity constraints – encouraging news for investment and employment.
A key point for investors is that Japan plc is in sound shape after the restructuring of recent years, with profit margins and return on equity at multi-year highs. Double-digit profit growth has been pencilled in for this year and next, while the broad market is on a historically low p/e of just 16 and no less than 40% of Japanese stocks trade at under book value; the world average is 2.4 times. Dividends are also rising, up 25% in the six months to October.
Global bargain hunters are likely to be drawn to Japanese stocks this year, says Shoji Hirakawa of UBS. And since everyone is underweight Japan, there is scope for “huge sums” to flow into Japanese equities, one manager told Austria’s Trend magazine.
Meanwhile, the recent rise of the Topix’s dividend yield above the ten-year government bond yield, historically a strong buy signal, and signs that domestic investors are returning to the market, also bode well. With the yen undervalued and sterling shaky, UK investors may also profit from currency gains this year. As Whitechurch Investment team puts it, Japan “could be a recovery play for 2008”.
Emerging markets
Emerging markets investors are popping champagne corks. The MSCI Emerging Markets index finished 2007 40% ahead in dollar terms; Brazil and India gained over 74%, followed by Turkey and China, up 66% and 63% respectively. Vastly improved fundamentals, thanks to the commodities boom and better economic management, have seen investors stampede into the sector.
But in 2008 the “perceived resilience of emerging markets [will be] truly tested”, says Deutsche Bank. Historically high valuations suggest investors see emerging markets as a safe haven amid global uncertainty. But can they really decouple from dwindling US growth?
Internal demand in export-led Asia is insufficient to offset slowing US consumption, says Stephen Roach of Morgan Stanley. That portends a rocky ride for emerging markets as risk-aversion mounts; Morgan Stanley recently estimated that a global retreat from stocks due to a US recession could wipe around a quarter off the currently overcooked Indian market in 2008. With this backdrop in mind, here are some views on the main emerging markets in the news.
Brazil: good prospects
After a fifth year of gains amid strong commodity exports and falling interest rates, many strategists are pencilling in another strong year for Brazilian equities. The central bank forecasts growth of 4.5% this year after 5.2% in 2007, and for the first time in ages, consumption and investment are both underpinning growth, making the upswing “solid”, says Alexandre Schwartsman of ABN Amro.
The car sector had a record year and credit growth is set to grow for years as consumers become wealthier; inflation at just 4% means there is also scope for further rate cuts, notes Arjun Divecha in Fortune.
Meanwhile, the p/e of 13 makes Brazil one of the cheaper emerging markets. Credit Suisse sees scope for a 35% gain in the benchmark Bovespa index, while bank and consumer stocks are likely to lead the market in 2008 as their strong results are not yet reflected in valuations, reckons Eduardo Favrin of HSBC Investments Brasil; iron ore and oil giants Vale and Petrobras also have “good growth prospects”. Divecha reckons the ETF tracking the MSCI Brazil index (IBZL) is worth a look.
China: less exciting?
Both domestic and foreign investors leapt on the China bandwagon in 2007, chasing the long-term potential in an economy growing at 11.5%. The rocketing domestic market, largely off limits to foreigners, is on a forward p/e of 32, while the index of Hong Kong-listed Chinese firms (around 70% cheaper), gained 40% in dollar terms.
But 2008 “may not be nearly as exciting”, as Jonathan Anderson of UBS points out. A US recession could sap export demand and the government is raising interest rates and restricting bank lending to cool the boom; further tightening will affect earnings growth, as Lex points out in the FT.
Sentiment has already been dented, with air hissing out of the domestic bubble and the Hong Kong index of Chinese firms down by around 18% over the past two months.
On the plus side, however, mainland retail investors look likely to be allowed to invest in Hong Kong as of the second quarter of 2008, according to HSBC, thus joining institutional investors; $27bn of private money could hit the Hong Kong market this year.
Jing Ulrich of JPMorgan Chase expects Hong Kong-listed China shares to outperform their mainland counterparts in 2008. One China play worth a look is the Gartmore China Opportunities fund, says Peter McGahan of Worldwide Financial Planning.
Hong Kong is generally appealing, as it is the only market in Asia where growth is accelerating while monetary policy is easing and real rates are falling, says Mark Matthews of Merrill Lynch. Inflation is ticking up while the dollar peg means that Hong Kong imports US monetary easing. Low real rates are good news for asset prices.
UK: cash looks most appealing
The FTSE 100 finished 2007 up a mere 3.5%, and the average City forecast in a Sunday Times survey implies almost no progress this year. There is plenty more subprime-related bad news to come, says Howard Wheeldon of BGC Partners; only when banks have “cleared the decks” can confidence recover.
Goldman Sachs expects a sharp slowdown in the US and the UK to dent the index by 5-10%. Earnings forecasts are likely to fall not just at banks – another problem will be increasing bad debts as the economy slows – but across the market amid a global growth slowdown, says Heather Connon in The Observer.
Morgan Stanley’s Graham Secker reckons UK earnings could actually slide this year, and says rate cuts, which the bulls hope will revive the economy and equities, may not help much given that consumers are already soaked in debt and banks are reluctant to lend.
So the market may be cheap on a p/e of around 12, but it’s likely to get cheaper, as one City veteran told The Sunday Times’s John Waples. Given all this, strategists’ tips include defensive large cap stocks and Neil Woodford’s Invesco Perpetual Income fund, but given the extent of the uncertainty over the outlook, the best bet is to “sit on your hands” and opt for the high desposit rates currently on offer, says Connon.
US: don’t count on an election rally
Since 1950, the Dow Jones index has risen in the last seven months of the year in 13 of 14 presidential election years, says Scott Patterson in The Wall Street Journal: incumbents typically try to bolster the feel-good factor with tax cuts and spending hikes. But investors would be unwise to count on this “dubious market predictor”, as Scott points out.
Note that the one year it didn’t work was in 2000, when the burst dotcom bubble led to recession, and a recession is looking likely this time too amid the accelerating housing bust (prices in ten major cities saw a record 6.7% annual decline in October), and tightening credit, which presage sliding consumption; disappointing holiday retail data are the latest omen on this front.
With the S&P 500 4% up this year, stocks seem to have “insufficiently considered a possible recession”, as Kopin Tan puts it charitably on Barrons.com; analysts expect profit growth of 14.7% across the year. On average, the market is down more than 20% in recessionary phases, as David Rosenberg of Merrill Lynch notes.
With earnings and the economy heading downwards – profits will shrink in the fourth quarter after sliding in the third – there’s a “gaping disconnect between Wall Street and the real world”, says Alan Abelson in Barron’s. The market is in for an unhappy ending.