2 November 2011

Four reasons why it’s not all about Europe

Max King, Strategist and Portfolio Manager, Investec Multi-Asset Investment team

The explanation favoured by the media for October’s exceptional market surge was that it was attributable to the “agreement” reached at the euro-zone summit, billed as the last chance to resolve the crisis. Inevitably, the reality was rather more complicated.

In our view, the market low seen in early October did not represent the capitulation of sentiment sought by contrarian investors as a true market turning point, but there was plenty to suggest that bearishness was exaggerated. Data from the US was pointing to improved growth rather than the dreaded double-dip recession, valuations were excellent, growth in corporate earnings strong and the risk of a global banking crisis diminishing. A solution to the euro-zone crisis was not required for the market to rally.

1)     Fears of a US recession were partly the result of disappointing data, partly of the assumption that the market sell-off in August was a leading economic indicator. However, broad money supply and bank lending to businesses have been growing steadily since early 2010, both important pre-conditions for growth. Business and consumer surveys were gloomy but hard economic data much less so. It should have been no surprise that third quarter annualised growth has been estimated at 2.5%, with more expected in the fourth quarter. While economic prospects in the distressed countries of the euro-zone remain dismal, growth is also likely to pick up in the UK, where excessive pessimism is rife, in Japan, recovering from the tsunami, in emerging markets, where interest rates and inflation are peaking, and in Northern Europe, where businesses remain competitive.

2)     It is not yet proving to be a problem for companies that economic growth is likely to remain sluggish. US nominal GDP has risen 3.5% to 4% in the last year but third quarter revenue growth for the S&P 500, on the basis of the 65% that have reported, is over 12% higher than a year ago, according to Wells Fargo Research, having been nearly 9% higher year-on-year last quarter. Growth may be lethargic but it is focused on the areas which are beneficial to companies, rather than on government spending and credit expansion. Companies are also benefiting from the increasing importance of exports and revenues of overseas subsidiaries. Though year-on-year revenue growth and earnings growth, running at nearly 17% year on year, are likely to fade, companies should be able to continue to grow revenues considerably faster than nominal GDP, and earnings even faster. The same is likely throughout developed markets.

3)     Global earnings forecasts have been fading but still point to low-teens increases for both 2011 and 2012, according to consensus forecasts at mid month. Downgrades have been numerous but growth forecasts have come down by only 5% for 2011 and by 1% for 2012^[1]. With 2011 nearly over, the scope for further downgrades is very limited. The danger that attractive multiples are undermined by falling earnings is remote. At the market low, equities were trading on below 11 times 2011 earnings and below 10 times 2012 earnings, way below historic averages or any reasonable estimate of fair value. On a prospective basis, equities were cheaper than they were at the March 2009 market low, when sharp falls in earnings were expected and subsequently experienced. In contrast, spreads on investment grade and high yield bonds, though attractive, were well below their 2008/9 crisis highs. A great deal of bad news was discounted by equity markets with a dwindling supply of sources for it.

4)     Europe ex the UK accounts for about 16% of the MSCI All Countries index. Excluding the non-euro zone countries of Scandinavia and Switzerland reduces the figure by a few percent and North Europe is hardly stressed. That means that less than 10% of global equities are in stressed markets; on an economic basis it is about the same. However severe the problems of 10% of the global economy and markets are, they are not enough, by themselves, to derail global prospects. For that, the fears prevalent in August of a Lehman-like banking collapse in Europe, spreading contagion around the world, would have to be valid. The consequences of the collapse of Lehman make it unlikely that arguments for imposing moral hazard on the banks would hold any sway, in our view. We think the bail-out of Dexia further reduces the probability of a significant insolvency being allowed to unfold.

 

What now for investors?

While markets rallied in October, investors remained focused solely on the euro-zone crisis. The rally was treated with universal scepticism, without regard for other factors. Applied to the “solutions” offered by euro-zone summit, that scepticism was wholly valid but it missed the point: markets could rally without a euro-zone solution. But it would be wrong to be complacent.

The euro-zone’s 14^th “crisis” summit in 21 months resolved nothing and may have only bought a respite of a few weeks.  The €106bn recapitalisation demanded from European banks covers no more than the 50% write-down of Greek debt held by the private sector and, inevitably, falls mainly on those who will be least able to raise capital from capital markets by themselves. The write-down of Greek debt is inadequate to make it solvent but enough to encourage other countries to demand comparable terms. Nearly 40% of the €440bn in the EFSF has already been committed, leaving just €280bn to cover Italy, Spain, the banking system and (given the recent sharp widening of spreads against Germany) maybe even France. Leveraging this with money borrowed from China looks like wishful thinking - why should they lend when the Germans won’t, unless it is heavily secured? Stretching it to cover partially future bond issues may spread it over €1tr but it would not cover existing bond issues and will, on current projections, run out in early 2013. Moreover, guaranteeing 20% of a bond issue does not make the remaining 80% attractive, nor will it materially reduce the yield demanded by investors. The subsequent jump in the yield of Italian 10 year bonds to above 6% blew an immediate raspberry at the proposals.

Without growth, of which there is little prospect in southern Europe given the lack of competitiveness of the economies, in our view bail-outs provide only an expensive stop-gap while insolvency remains inevitable. The mantra of commentators now is to demand that the ECB implements quantitative easing, as if there was evidence that this would solve the problem. More importantly, it directly contradicts both Article 123 of the Lisbon treaty and an explicit prohibition by the German Bundestag when they approved the summit package. Quantitative easing by the ECB would precipitate a constitutional crisis.

It is inevitable that the euro-zone crisis will continue to dominate markets. It did not prevent a market rally and markets should, in the medium term, be able to grind erratically higher without a resolution. The banking problems of the euro-zone are a long way from being recognised and quantified, let alone resolved, and will continue to undermine global markets. While it was right to add to equity exposure in early October, it is likely to prove prudent to reduce exposure into strength. Investors who missed the rally are likely to get another chance.

 

[1] Source: Societe Generale

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ENDS

Notes to Editors

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