It’s All About Earnings and Valuations but Mostly About Interest Rates!

• All other things being equal, rising interest rates exert a negative influence on asset prices. They reduce the present value of a stream of earnings and raise default risk. They lower fair values in equity markets and widen credit spreads in bond markets and do much the same in the markets for credit derivatives. They encourage risk aversion. Adventure no longer beckons. Caution prevails and investors retreat from the less liquid areas of asset markets. There is a flight to quality.
  

• But all other things aren’t equal. Interest rates have been rising for some time and yet equity markets have made their way defiantly onwards and upwards. As the chart shows, the recent rise in bond yields has not been associated with a correction to speak of in global equity markets. This is because interest rates aren’t likely to rise by much more, yields in government bond markets have gone about as far up as they’re probably going, earnings are continuing to grow, valuations remain favourable and there’s still a lot of corporate activity.
  

• Almost from inception, this bull market has been challenged by numerous obstacles and has dared to overcome them. The trebling of oil prices, the Fed’s policy of normalization (which lasted two years and saw rates rise at pretty well every FOMC meeting over that period - from 1 percent to the present 5.25 percent), war in the Middle East, including the war that erupted between Israel and Shi'ite Hezbollah guerrillas in Lebanon, and the constant threat of terrorism, all of this has failed to de-rail the equity markets.

• Among the ‘known knowns’ that could bring this bull market to an end, i.e., factors that are identifiable and quantifiable, the one that stands out as being a negative influence is the tightening bias in monetary policies.

• Otherwise, valuations haven’t changed. As the chart below shows, global equity markets have climbed to new highs (solid line) but prospective p/e ratios (dotted line) are where they were, more or less, when this bull market started. All that investors have done is push equity markets up in line with earnings. Bond-equity earnings yield ratios are also still low relative to where they have stood over the past 20 years. The valuation excesses of the dot com boom are not present today and that’s good news for equity markets.

• However, valuations are only as good, or as credible, as the earnings on which they are based. Earnings growth is slowing. No surprise there! The high double digit growth of the past four years was always unsustainable. Importantly though, the surprises have remained on the upside.
 

• In the US, where the numbers are readily available and where earnings growth for the first quarter of 2007 fell into single digit territory for the first time since the second quarter of 2003, the outcome reported by companies was more than twice the consensus expectation.

• US companies are about to report for the second quarter - a few have already - and single digit growth is also expected but the consensus estimates are edging up. The combination of strong global growth and the softer dollar means that the earnings surprises could still be on the upside for the S&P 500, and that’s good news for equity markets.

• Central bank policies are geared towards restraint and that’s the bad news but they’ve been that way for a while. Higher interest rates can be expected to increase volatility in equity markets and to widen credit spreads in bond markets but does that spell the beginning of the end?

• Not really. We think interest rates aren’t going much higher. We expect Fed Funds to remain on hold for the remainder of the year. They aren’t coming down and the Fed doesn’t want to risk destabilizing the housing market by putting them up. In the UK, we doubt that base rates will rise beyond 6 percent and, in the eurozone, we expect the ECB to put policy on hold when its main refinancing rate reaches 4.5 percent. That’s another 50 basis points from where it is now.

• This degree of monetary restraint does not have the feel of overkill. It needn’t bring earnings growth to an end, though it will slow it down and, as we have said, earnings could still surprise on the upside. Valuations still look favourable. Also, yields at the quality end of the corporate debt markets (i.e., triple B or better) aren’t yet high enough in relation to earnings yields in equity markets to bring the takeover binge to an end. This is particularly so in the UK and the eurozone and less so in the US.

• The very features that have helped drive the bull market are still largely beneficent for equity markets. Corrections have proved to be buying opportunities and another may be on the cards but, thus far, equity markets have done no more than trade down a little, trade up a little, trade sideways.

• Our bet is that the bull market will survive the subprime meltdown. Relative to the US mortgage market, subprime is small. On the face of it, consumer confidence, which tends to be greatly influenced by jobs, has been unaffected and, latterly, more jobs have been created than expected.

• Then there’s the big wide world out there. The global economy is growing more strongly than expected and generating lots of earnings for companies. As a problem for global equity markets, subprime just doesn’t stack up. It may be another matter for the world of structured finance and for the holders of credit derivatives.

• As noted before, we see more risk to being out of equity markets than in them. The bears may not see it that way but then, if the truth be known, they’re probably still fully invested anyway.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.