Darkest before the dawn

Published November 2, 2011

MONEY MATTERS


What are equity markets pricing? And what does that mean for investors?


By HAREN SHAH


RECENT months have seen global investors go from being a fairly positive group to one that is overly nervous - even panicky, some might say. Since their April highs, most markets have experienced significant falls and a number have declined by more than 20 per cent, heading into bear market territory. So the question is: What are investors worried about and what are they pricing into equity markets?


There are three parts to the answer. The first concern is that the fiscal crisis in Europe is spreading and could cause a global banking meltdown similar to what was seen in 2008. Second, the lack of progress in lowering unemployment in the United States may result in a double-dip recession there.

And finally, there are growing concerns that China is slowing down and could experience a hard landing. All of these issues are related and the fear is that one, if not all, of these events could drive the global economy into a recession and affect corporate earnings.

The International Monetary Fund (IMF) has recently raised concerns about the headwinds facing the global economy. In its most recent review, it downgraded the outlook for most economies, but still expects the global economy to grow at around 4 per cent in 2011/12. Even in the US, where the consensus growth forecast has been reduced by an average of one per cent, the numbers are still positive. This aligns with the view of Citi economists, who do not believe we are headed for a recession, but do acknowledge that growth is slowing.

Looking beyond the problems in Europe and the US, China has also been an area of concern for many investors. Monetary tightening since the beginning of this year to fight inflation and curbs to arrest rising property prices have raised fears of a hard landing for China's economy. Recent data on inflation, which continues to remain elevated, and continued upside pressure on property prices may see this tight monetary policy persist to the end of this year.

More importantly, there are major fears that the large infusion of credit over the past few years could lead to a dramatic rise in bad debts, especially from local government entities.

Against this backdrop, and with continued poor manufacturing and consumer confidence data globally, equities are reflecting investor nervousness about a sharp retreat in corporate profitability. Indeed, Purchasing Managers Index (PMI) data from the US and Europe has shown them recently fall below 50, suggesting the manufacturing sectors there are contracting.

This is reflected in equity market valuations which are now discounting a significant falloff in earnings next year. Yes, analyst earnings revisions have had their weakest five weeks and while earnings downgrades have yet to show clear signs of easing up, they are not worsening either (see Chart 1).

Currently, Citi analysts forecast 2 per cent global earnings per share (EPS) growth in 2012 - well below the consensus of 13 per cent but well above the 25 per cent contraction that we think is currently priced in.

Even when we look at historical price-to-book values (P/BV), markets currently are down to attractive levels but not yet at the levels we saw back in 2008. For example, global equities as measured by the MSCI World Index are currently trading at roughly 1.5x P/BV - 25 per cent higher than the low seen at the depths of the last bear market (see Chart 2).

So where does this leave the investor? Short term, we are going to have to deal with the market volatility. Issues - especially those regarding the European sovereign debt problems - will need to be resolved before investor confidence stabilises. Even then, there are many other concerns that will continue to affect sentiment and market uncertainties. But for longer-term investors, value is showing up and they should view this weakness as an opportunity to look for companies with good balance sheets that are paying decent dividends. Ultimately, investors need to balance returns with risk and be broadly diversified.

The writer is director and senior investment strategist, Asia Pacific at Citi Private Bank

Disclaimer: Opinions expressed herein should be regarded solely as general market commentary, and may change without prior notice. Past performance is no guarantee of future results