Equity markets last month delivered some of their weakest performances for decades. However, despite fears about the impact of an American slowdown, the outlook for equities is promising.
The deteriorating economic and financial backdrop in America and concerns over the knock-on impact to the hitherto resilient global economy led equity markets to post some of their weakest performance for decades in January. Signs of a deteriorating American labour market, plummeting consumer confidence, an ongoing deflation in domestic housing prices, and fears over an end, and reversal of, credit creation have led many to conclude that recession in America has arrived and, furthermore, view a global downturn as inevitable. Indeed, buoyed by the relentlessly pessimistic economic and corporate news, more market commentators have concluded that the bull market is over.
The bears’ direct extrapolation of macro outlook onto market outlook, while seductive based on some of the historical analysis, is flawed. One does not have to be a bull of the macroeconomic outlook to see opportunities in stocks at current levels.
Recent news flow on the credit crunch has continued to drive negative sentiment, with easing conditions in the inter-bank lending market being countered by further write-downs in the financial sector and fears of downgrades to the AAA-credit ratings of monoline bond insurers, such as Ambac. These concerns have been compounded by growing fears of an American recession, which gained more credence on weaker data releases.
Indeed, the jump in initial weekly jobless claims unnerved those who had been counting on the solid labour market to support the case for a soft landing. Alongside figures from the Institute of Supply Management (ISM) that showed American manufacturing activity contracted in December, rising unemployment and a fall in non-farm payrolls data do make an American recession look a more real possibility. They also led to a “consensus capitulation” from the previously expected “soft landing” expectations, towards widespread expectations of recession.
These developments have dominated market sentiment and signs of turmoil in the financial markets, combined with the concerning economic picture, culminated with the Federal Reserve’s one and a quarter points of rate cuts in January. This has helped, in the short term, to restore confidence in the ability of central banks to manage the cycle.
The bears have been pushed back from the brink by market reaction to the interest rate cuts and, once more, pessimists vent the argument that a bear market rally foreshadows the fact that the Fed will be seen to be pushing on a string.
Despite these concerns, investors should have cause for greater optimism. It is appropriate that the deterioration in American leading indicators justifies downward revisions to growth expectations. Regardless, even with growth in American and major western economies hitting 1-1.5% this year it is likely that global growth for 2008 will be about 3-3.5%, compared with 4.7% in 2007.
Acknowledging this softer economic environment also warrants some price adjustment in stockmarkets. However, January’s sell-off saw our risk appetite indicators signal that panic had been reached for the first time since 2003 – a useful contrarian indicator. Given that markets have made such significant moves based on relatively limited news flow, the scale of the sell-off looks overdone, particularly if rate cuts and the proposed $146 billion (£73 billion) government stimulus packages succeed in easing the American economic slowdown.
Even if we do see an American recession in the first half of 2008, this substantial monetary loosening should ensure that the weaker environment is short-lived. Although tighter credit conditions are expected to put a drag on a recovery in the housing market, improving affordability should help the picture look more positive by the end of the year.
With corporate earnings estimates looking inflated at the end of 2007, adjustments to profit expectations are forecast and we will see more downwards guidance in coming months. Indeed, previous recessions have seen declines in market earnings in the region of 20%, which is well below market expectations, which still forecast double digit earnings growth this year. Unfortunately, analyst estimates are a poor guide to price movement at the market level, and must be combined with valuation metrics to yield meaningful insight.
When we assess valuation in equity markets, much of the concern is in the price. Prospective global equity multiples are already pricing in a material decline in earnings and, relative to both cash and bonds, equities are attractively valued over longer time-frames.
Signs of capitulation, which we had in January, and value in markets can provide a potent mix for investors. With widespread panic driving prices down to undervalued levels in January, the outlook for the nimble equity investor looks more attractive now than at almost any point in the past year.
“The outlook for the nimble equity investor looks more attractive now than at any point last year”