By Mike Lenhoff 26/01/2007 00:00
Rising bond yields and earnings downgrades are an unwelcome combination for equity markets, or so we thought. But who’s bothered?

Not even the one market that tends to be acutely sensitive to the winds of change is showing any concern. As the chart shows, yield differentials between triple B and triple A US and UK corporate bonds have actually narrowed. In the latter’s case, the spread is at its narrowest this decade. If trouble is brewing these spreads should be widening, but they’re not.

Okay, so maybe our concerns about equity markets are overdone. Perhaps what the corporate bond markets are saying is that the corporate sector is in fundamentally good shape, globally. Since the major equity markets derive a sizable proportion of their earnings overseas, what matters is the health of the global economy. For an index like the FTSE 100, where some 70 percent of its sales originate overseas, a rise in UK interest rates is likely to be of no more relevance to a large number of the blue chips than another barnacle on an oil tanker, though it is doubtful the same could be said of the S&P 500 if US interest rates were to rise further.

Investors have abandoned the prospect of an early cut in the Fed Funds rate. They may even be coming round to the idea that there will be no rate cut at all. But who’s discounting another phase of Fed tightening? The US Treasury market may be on to it, but few others are. In the UK, the gilt market (see chart on next page) is now clearly anticipating further rate rises.

US companies are in the midst of reporting their earnings for the last calendar quarter of 2006. Over a third of the S&P 500 has reported and, while the techs and the financials have done well, on balance the results lack the lustre of previous quarters. Since 2003, the proportion of companies delivering earnings at least as good as expected has often been twice, if not three times higher than what it is this time round.

However, all this should be in the market. What is unlikely to be in the market is the relevant news flow for the earnings expected for the first quarter of this year. That news flow is not yet known but the ‘pre-announcements’ for first quarter earnings growth for the S&P 500 provide an idea of its likely direction.

According to Thomson Financial, the ratio of negative to positive pre-announcements is considerably larger than it was at the corresponding stages a year ago or in the final quarter of last year and analysts’ are taking down their estimates. At the start of this month, the consensus expectation for earnings growth for the first quarter of 2007 was 8.7 percent but, at last count, this was lowered to 7.3 percent and the downward revisions probably won’t stop there.

Earnings downgrades not only raise prospective p/e ratios but they also lower fair values, thus making the equity market look either overvalued or, in the present case, less attractively valued than before. But rising bond yields depress fair values too.

So the risks are there for equity markets.

Yet, there is still plenty of confidence in the prospects for the global economy. Also, central bankers are more conscious than ever of the role that low and stable inflation plays in macro economic stability. Maybe the corporate bond markets reckon that a few downgrades in earnings are neither here nor there if credible central bank policies help maintain confidence in the outlook for earnings growth.

So it’s thumbs up from corporate bond markets and, while that doesn’t mean there won’t be volatility, it’s probably means that that underlying trend in equity markets is still up.

* 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 necessarily 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 necessarily 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.