I’m also sure I’ve made the technical point that each correction ended with a higher low than the low of the correction that preceded it, a pattern normally associated with a bull market. On the view that we’ve seen the low for this correction, the pattern of ‘higher lows’ has yet to be broken. I take that to mean we’re still in a long term bull market.
But there is a problem, to state the obvious, and at the heart of it lies the US economy, where monetary policy has just eased. GDP growth for this year is expected to come in at around 2 percent, a consensus forecast that hasn’t changed a great deal in recent months. However, for next year, the consensus has cut its forecast for GDP growth to 2.4 percent - about half a percentage point less than it was three months ago. Given the developing weakness in the labour market and a housing market that is proving to be weaker than expected, the consensus forecast for GDP growth will, doubtless, be cut again. And probably again after that!
Fundamentals for the equity markets are thus changing. Earnings growth is already slowing as the chart shows and it is set to slow further. After a lengthy period of positive earnings surprises, negative earnings surprises are now the risk for equity markets.
Yet according to Thomson Financial, US earnings growth is expected to accelerate to nearly 12 percent in 2008 from 8 percent this year. That doesn’t jive with the likely outcome for GDP growth next year. A good part of the earnings expected for this year is already in the bag but next year’s number isn’t credible. What then is credible or, more to the point, where’s the downside for earnings?
To shed some light on this, an attempt was made to quantify the relationship between US GDP growth and earnings growth. This was then used to derive the earnings growth that might be expected under alternative assumptions for GDP growth. The following table presents the results of the exercise in the form of a ready reckoner.
The first column in the table shows a range of assumptions for US GDP growth and the second column shows our estimate for the earnings growth that corresponds to the each assumption for GDP growth. The third and fourth columns show the difference between the earnings estimate from our ready reckoner, i.e., the second column, and the current consensus estimates for earnings growth for the S&P 500 for 2007 (8 percent) and 2008 (11.9 percent) respectively.
For example, our ready reckoner shows that the earnings growth for the S&P 500 associated with the 2 percent GDP growth the consensus is forecasting for this year is 5.1 percent - 2.9 percentage points less than analysts are currently expecting for this year. That’s not a lot.
For 2008, the earnings growth associated with the consensus forecast of 2.4 percent GDP growth is 6.8 percent - 5.1 percentage points less than the analysts are currently expecting for next year.
Given the risks to the economy - the prospect that GDP growth for 2008 could be revised even lower, say to 2 percent or 1 percent, or worse - the table shows there is potentially a lot more downside to next year’s consensus earnings estimate. For example, the earnings growth corresponding to GDP growth of only 1 percent is a measly 0.8 percent, which implies that pretty well all of next year’s consensus earnings growth could be fluff and blow away.
The point is that consensus earnings expectations for 2008 are far too ambitious; there’s a lot of downside and hence scope for some nasty earnings surprises. The other point is that if corporate earnings are at risk in the US, they are likely to be at risk elsewhere. The US may not have quite the impact on global trade and growth it once had, but it’s hard to imagine that a serious slowdown won’t be felt worldwide.
But is the news really so bad for equity markets? I don’t think so!
The Fed has knocked 50 ‘bips’ off the Funds rate. While that, on its own, is unlikely to be enough to brake and then reverse the economy’s loss of momentum, it’s a good start in the right direction. By cutting rates as it did the Fed is saying it means business in providing relief for the economy. Another 50 basis points of cuts is likely by year-end, i.e., this year-end! And if need be there will be more cuts, all of which should help mitigate the severity of any slowdown and sow the seeds of recovery. However, it all takes time.
Interest rates are also likely to be cut elsewhere, notably by the Bank of England and the European Central Bank, partly because of the wash back from the slowing US economy and partly because of the effect on trade from a weakening dollar. In the UK and the Eurozone, we expect policy rates to come down by 50 basis points by the Spring of next year if not before. In Japan, rates will stay where they are.
As for the developing economies, Asia (ex Japan) can be expected to continue growing strongly, thus supporting global growth, and indeed, growth in other emerging economies. If anything, the emerging giants of Asia are continuing to grow too fast for comfort. That has its downside, as discussed shortly, but it’s still good news for US exporters, who benefit from the dollar’s weakness and the enhanced international competitive position they derive by it.
There’s much that remains positive about the outlook. We think a recession can be avoided and that the US economy will end up growing by around 2 percent next year. Using our ready reckoner, we are then talking about earnings growth of around 5 percent for 2008, more or less what it suggests for this year.
According to Thomson Financial, the S&P 500 sells on a twelve month forward p/e ratio of 15.2 but that’s using the existing consensus earnings estimates of 8 and 11.9 percent for this year and next respectively. If instead we use the 5 percent growth for each 2007 and 2008 that comes out of our ready reckoner, this pushes up the twelve months forward p/e ratio to 16.
As the chart below shows, this prospective p/e ratio is higher than we have seen it in recent years but not as high as it was in the earlier stages of this bull market. The rating leaves Wall Street looking neither cheap nor dear, though it has to be said that a p/e of 16 offers more comfort when earnings growth is rebounding and the consensus is revising up its earnings estimates than when earnings growth is slowing and the consensus is revising down its earnings estimates.
If the consensus estimates for earnings growth for the FTSE 100 are reduced in proportion to the reduction in earnings growth suggested by our ready reckoner for the S&P 500, the prospective p/e ratio for the FTSE 100 rises from just under 12 to around 12.6. This is smack in line with what the FTSE 100’s 12-month forward p/e ratio has averaged throughout the entire bull market. The FTSE 100 continues to look quite satisfactorily valued even allowing for earnings downgrades.
Valuation is thus not really an issue for the major equity markets and when you look at bond-equity earnings yield ratios, they are still at the low end of the ranges. For the major equity markets it’s really all about earnings and interest rates.
There aren’t too many economic problems that judicious cuts in interest rates can’t solve, though deflation might be one of them. Yet who’s talking about deflation. All the talk’s about inflation on the back of rising commodity prices - softs as well as the hards. Gold, that great harbinger of inflation, is closing in on its all time high of January 1980. But inflation is not what we’ve got. Yields on 10-year US Treasuries are just about average for this cycle and moreover, the yield curve reflects only a little term premium.
Right now inflation is low and moderating and, as pointed out in previous notes (see Judgment Day Ahead – 50 bps off the Funds Rate! 12 September 2008 and Action Speaks Louder Than Words! So What Now? 19 September 2008), the risk, among others, is that the contractionary forces of a credit crunch take the disinflationary impulse of a severe US slowdown or recession down the road no one wants to go, i.e., towards deflation. It’s a risk that matters for Fed policy and part of the reason for our thinking that rates will continue to be cut.
What’s the bottom line for equity markets? The majors are likely to take their lead from Wall Street and, with earnings likely to be downgraded, the equity markets are likely to encounter resistance. However, the US equity market is also likely to take its cue from the Fed and be reassured by its assertive stance on policy. That we feel could help keep its underlying tone surprisingly firm.
Emerging markets have been remarkably resilient but some aren’t exactly cheap now. Take China. As the chart below shows, the prospective 12 months forward p/e ratio has climbed to a considerable premium to the US equity market. The strength of the economy means that earnings will not be revised away entirely but interest rates will continue to rise and, sooner or later, the market will react - and big time!
A final word on the latent inflationary pressures about. The Fed has not taken its eye off the ball but there is a view that, by easing as it has, the Fed risks losing credibility. I’m not so sure. By acting promptly and smartly, that is by injecting liquidity into the markets, by cutting the discount rate initially and continuing to accept a wide range of instruments as collateral and, latterly, by cutting the Funds rate and again the discount rate, I think it has enhanced its credibility. But let’s let the markets judge!
