Special report: Are we there yet?
James Forbes, senior equity strategist for Irish Life Investment Managers charts recent movements in global equity markets and reckons there will be mixed data for the next six months.
After enduring the heavy traffic of a bank holiday weekend, with three young kids in the back of the car, the last words I want to hear is “Are we there yet?” However, this is the question investors are asking following the recent lows and subsequent rally in equity markets.
Equity market investors have endured a roller coaster ride during the first four months of 2008. The FTSE World Index (in euro terms) fell by almost 20% by March 17, however, markets then began to recover and, by the end of April, the index was down 8.8%. The wall of worry continued to grow in the first few months of 2008, with the increased probability of a US recession, falling house prices and rising strains on the global financial system.
Against this backdrop, the Federal Reserve has been trying to stimulate the US economy (and banking system) by reducing interest rates. US interest rates have been cut four times thus far in 2008, with rates having fallen from 4.25% at the year end to the current level of 2.0%.
The news flow reported in the media has generally been quite negative, but in terms of actual equity markets there has been a significant divergence in performance. The S&P500 has fallen by 4% in the first four months (indeed the Dow Jones i
s off just 2% year to date), while European markets have generally suffered declines in the region of 12%. Emerging markets continue to perform well, with regions such as Mexico and Brazil posting positive returns of 2% and 6% respectively in the first four months of 2008.
Emerging markets continue to perform well, with regions such as Mexico and Brazil posting positive returns of 2% and 6% respectively in the first four months of 2008.
The weekend around St Patrick’s Day marked the low for equity markets with the collapse of Bear Stearns and subsequent rescue of the Wall Street broker by JPMorgan. It was almost as if this was the bad news that markets needed before they could move on. Over the last few months, there has been significant “shoring up” of balance sheets by many of the global banks via rights issues to shareholders. This has generally been viewed positively as it ultimately put the banks on a firmer capital position.
Sell in May and go away?
As we enter the summer months, equity markets have enjoyed something of a relief rally on the back of slightly better-than-expected first-quarter earnings. However, there are still two major headwinds facing investors over the next few months. First, while corporate bond spreads have narrowed somewhat, three-month money still remains stubbornly high (Euribor at 4.85%). This continues to suggest significant pressure remains within the financial system, and it will probably take more action by central banks, such as accepting asset-backed securities as collateral for government loans.
Second, the macro data out of the US continues to weaken and, with no signs of a recovery in the housing market, risks remain to bottom-up earnings forecasts as we move towards the half year. Currently, equity analysts are forecasting that S&P500 earnings will increase by 13% in 2008. This is too optimistic and will have to be reduced over the next few months.
So are we there yet? While there have been significant writedowns by the banks over the last six months, investors should expect that there will be further credit-related charges to be taken over the next quarter, albeit at lesser amounts than we have seen previously. Real estate prices continue to remain under pressure, particularly in the US and the UK, and after enduring the credit crisis over the last 12 months, banks in the next 12 months may have to start increasing in bad-debt provisions. This would adversely impact the earnings recovery story.
At this juncture, investors will require increased confidence in earnings before pushing markets significantly higher. The likelihood is that the economic data will be somewhat mixed over the next quarter or two, and thus equity markets are likely to be range-bound until the prospects for the economic backdrop become clearer.
The domino effect
The financial crisis, which began brewing in the US subprime mortgage market in the summer months, spread throughout credit markets in the last quarter of 2007. Whole new acronyms and words sprung up in the investment dictionary – SIVs (special investment vehicles), CDOs (collateralised debt obligations), CLOs (collateralised loan obligations) and apparently “conduits” can be developed beyond the physics laboratory to purchase assets via the issuance of commercial paper!
In essence, the deflating of the global credit bubble resulted in significant declines in the prices of credit instruments, which in turn had a detrimental impact upon bank balance sheets and hence their future ability to lend. Many of the leading global banks incurred massive “asset write downs” which resulted in over $150 billion of special impairment charges.
Tight lending conditions in the US mortgage market continued to put pressure on both activity levels and house prices. Indeed, the latest data available recorded a 7.7% year-on-year decline in the Case Shiller Home Price Index. With the banking sector under pressure, coupled with concerns over consumer spending due to the weaker housing market, the risks of a US recession rose throughout the quarter.
The Federal Reserve initially cut interest rates by 0.5% to 4.75% in September and in Q4 cut interest rates by a further 0.5%. The ECB continued to lose sleep over Eurozone inflation data and its soundings over the last quarter have suggested interest rates will remain on hold at 4% in the medium term.
So are we there yet? While there have been significant writedowns by the banks over the last six months, investors should expect that there will be further credit-related charges to be taken over the next quarter, albeit at lesser amounts than we have seen previously. Real estate prices continue to remain under pressure, particularly in the US and the UK, and after enduring the credit crisis over the last 12 months, banks in the next 12 months may have to start increasing in bad-debt provisions. This would adversely impact the earnings recovery story. At this juncture, investors will require increased confidence in earnings before pushing markets significantly higher. The likelihood is that the economic data will be somewhat mixed over the next quarter or two, and thus equity markets are likely to be range-bound until the prospects for the economic backdrop become clearer.
Equity markets in Q4
Concerns about the weakening economic backdrop in the US and Eurozone put equity markets on the back foot in Q4. The FTSE World Index (in euro terms) declined by 4.1% in Q4. Even with the interest rate cuts in the US, the S&P500 still posted a 3.8% fall in the quarter, whilst European markets declined by just 1.2%. Moving closer to home, the ISEQ remained unloved by overseas investors due to its large exposure towards financial stocks and concerns over the local housing market. The ISEQ fell by 12% in Q4.
January capitulation
The “wall of worry” facing equity investors grew even larger in January following weak December employment data in the US and the results of a survey which showed US manufacturing in recession territory (although it should be noted that manufacturing accounts for less than 30% of US economic activity). Significant volatility in global equity markets also caused concern for policy makers. The Federal Reserve held an emergency teleconference on January 22 and cut US interest rates by a further 0.75%. This was the first “emergency meeting” since the terrorist attacks in the US in 2001 and was the largest interest rate cut in over 25 years. At the end of January, the Fed cut interest rates by a further 0.5% to 3.0%.
Equity investors can take some encouragement that the Fed has been proactive in providing liquidity into the US economy. There is no doubt that economic data from the US in the first half of 2008 will remain weak (and indeed the US housing market is not likely to recover until some time in 2009). However, equity investors are typically more forward looking and should already be discounting this bad news.
In mid January, the US market had fallen by over 16% from its high in October. I believe that this “correction” in prices more than reflects investor concerns over earnings in 2008. Wall Street analysts are forecasting that 2008 earnings will grow by over 15%. This rate of earnings growth is too high and will have to be lowered as we move through 2008. However, the recent earnings reports of the non-financial companies would continue to suggest modest growth in 2008 (largely driven by the overseas operations of US companies). Assuming modest single digit earnings growth for US companies, and applying a 20-year average P/E multiple to these earnings, this would suggest fair value for the S&P at 1,535 over the next 12-18 months (15% higher than current levels).
However, market volatility is likely to remain very high over the next few months. In these volatile market conditions it is important for investors to remain calm and not to be tempted into making investment decisions on the back of media headlines. The Bearish Sentiment Index reading at the end of January was at its highest level in eight years. However, this reading is often a contrarian indicator and suggests that most of the bad news has already been reflected in equity prices. Let’s see if the theory works this time.
Equity investors can take some encouragement that the Fed has been proactive in providing liquidity into the US economy. There is no doubt that economic data from the US in the first half of 2008 will remain weak (and indeed the US housing market is not likely to recover until some time in 2009). However, equity investors are typically more forward looking and should already be discounting this bad news.
I believe that this “correction” in prices more than reflects investor concerns over earnings in 2008. Wall Street analysts are forecasting that 2008 earnings will grow by over 15%. This rate of earnings growth is too high and will have to be lowered as we move through 2008. However, the recent earnings reports of the non-financial companies would continue to suggest modest growth in 2008 (largely driven by the overseas operations of US companies). Assuming modest single digit earnings growth for US companies, and applying a 20-year average P/E multiple to these earnings, this would suggest fair value for the S&P at 1,535 over the next 12-18 months (15% higher than current levels).
However, market volatility is likely to remain very high over the next few months. In these volatile market conditions it is important for investors to remain calm and not to be tempted into making investment decisions on the back of media headlines. The Bearish Sentiment Index reading at the end of January was at its highest level in eight years. However, this reading is often a contrarian indicator and suggests that most of the bad news has already been reflected in equity prices. Let’s see if the theory works this time.
US interest rates have been cut four times thus far in 2008, with rates having fallen from 4.25% at the year end to the current level of 2.0%.
The news flow reported in the media has generally been quite negative, but in terms of actual equity markets there has been a significant divergence in performance. The S&P500 has fallen by 4% in the first four months (indeed the Dow Jones is off just 2% year to date), while European markets have generally suffered declines in the region of 12%. Emerging markets continue to perform well, with regions such as Mexico and Brazil posting positive returns of 2% and 6% respectively in the first four months of 2008.
The news flow reported in the media has generally been quite negative, but in terms of actual equity markets there has been a significant divergence in performance. The S&P500 has fallen by 4% in the first four months (indeed the Dow Jones is off just 2% year to date), while European markets have generally suffered declines in the region of 12%. Emerging markets continue to perform well, with regions such as Mexico and Brazil posting positive returns of 2% and 6% respectively in the first four months of 2008.
Second, the macro data out of the US continues to weaken and, with no signs of a recovery in the housing market, risks remain to bottom-up earnings forecasts as we move towards the half year. Currently, equity analysts are forecasting that S&P500 earnings will increase by 13% in 2008. This is too optimistic and will have to be
James Forbes is the senior equity strategist for Irish Life Investment Managers. Irish Life Investment Managers is regulated by the Financial Regulator. Past performance may not be a guide to future performance. Investments may rise as well as fall
Are we there yet?
in association with BearingPoint
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