If anything has been liquidity driven it has been the global economy. Historically low interest rates paved the way for the upswing in the business cycle that followed the dot com bust. One of the worst corporate recessions on record was brought to an end and, from that point onwards, the risk premia in credit markets continued to narrow.
As the chart shows, that narrowing has been abruptly halted by the subprime fallout. The credit markets have reacted strongly thus making it less easy than before for investing institutions to attract or retain funds and for companies to raise money to finance their growth or their takeovers. The great unknown is the extent to which four and half years of compression in quality spreads will unwind.
Shifts in monetary policy tend to be associated with changes in the volatility of asset markets. Interest rates were reduced to unsustainably low levels. Now central bank policies are geared towards restraint, or normalization. We see the adjustment in the credit markets as reflecting the volatility associated with a change in monetary policy. However, adjustments don’t just happen automatically. They need a catalyst. The subprime fallout has been the catalyst.
For equity markets, one can imagine that the worry is not that the subprime fallout brings indiscriminate lending practices to an end, but that, in one way or another, it brings to an end the expansion in the global economy and with this, an end to the growth in corporate profits. More to the point, the risk for equity markets is that a lengthy phase of positive earnings surprises turns into a lengthy phase of earnings disappointments.
In fact the real surprise to date has been how consistently positive the earnings surprises have been over the past four years. To take the US as an example, earnings have fallen short of consensus expectations in only two quarters since the Spring of 2003 and the impact of hurricane Katrina on the US economy accounted for the shortfall in one of these quarters.
Even now, in the midst of America’s seriously weak housing market, corporate earnings are continuing to exceed expectations. At the start of the second quarter the consensus expectation for the earnings growth that US companies are now reporting was 3.9 percent but the running tally for the 82 percent of the S&P 500 that has reported thus far is 6.8 percent and rising. The first quarter of this year saw the weakest growth in US GDP since the economic expansion began and yet earnings growth exceeded the expectation held at the start of that quarter by more than twice. Earnings are just continuing to surprise by their strength.
A point we have made repeatedly for some while now is that the major equity markets - the blue chips in particular - have been not so much liquidity driven as earnings driven. As the chart below shows, investors have chosen to mark up global equity markets broadly in line with the rise in earnings. That’s why p/e ratios today are more or less what they were in the Spring of 2003. The valuation excesses that brought the last bull market to an end remain absent in this bull market.
A Bernanke led Fed will be acutely sensitive to the latest developments in the credit markets for two reasons. First, because of the prospect that they might swing the balance of risks to the downside for economic growth and profitability and second, because of the deflationary consequences of a fully fledged credit contraction. The good news is that, not only has the Fed plenty of scope to cut interest rates, but also that a Bernanke led Fed will take a leaf out Japan’s deflationary experience and respond sooner rather than later - and assertively.
For equity markets, the fundamentals still look positive. If anything, valuations have even improved by virtue of last week’s sell-off. Earnings are still being upgraded, for this year and for next, and there is still a lot of dividend growth. Alright, so the private equity groups are being forced to re-think any ambition about take-overs in the publicly quoted sector, but public companies are continuing to buy back their shares. Does all that sound bearish or bullish? Our view is that all we’re seeing is another correction in a secular bull market.
Buying opportunities seldom look like buying opportunities until well after the event. The major equity markets are to varying degrees technically oversold and due a rebound. Wall Street is less oversold than other markets and so there may be more selling but one is never likely to time it perfectly and no one ever rings the bell at the bottom. We feel equity markets offer a buying opportunity around these levels. In December of last year we set our targets for the FTSE 100 and the S&P 500 at 6550 and 1525 respectively for end 2007. The targets haven’t changed.
Greed, not liquidity, generates excesses, and big bets, and mishaps, and fear! There is no more powerful force to tempt greed than the momentum underlying a bull market. But where are the excesses if they’re not in the equity markets? In the credit markets? Probably!
Yield spreads were pushed well below the boundaries of what might be considered sustainable against the backdrop of central bank policy normalization. We expect the adjustment in credit spreads to be no more that a restoration of risk premia to some more ‘normal’ levels. If that is all there is to it, then the underlying trend in equity markets, which sell on more or less the same p/e ratios they did at the start of the bull market (dotted line in the chart below), will remain upward.
