On the other hand, maybe the other major equity markets will follow Japan. Thus far they have given up a third of their bull market gain and, if they retrace 50 percent of it, we would then be talking about 5000 for the FTSE 100 and 1170 for the S&P 500, about another 15 percent drop. We’ll come back to this.
As the chart shows, the earnings recessions of the early 1990s and of the new millennium (dotted line) were both associated with widening spreads on higher yielding corporate debt (solid line). On each occasion, the spreads widened by roughly the same amount, i.e., by between 900 and 1000 basis points.
Equity markets behaved quite differently in and around these recessions except in one important respect. This was that a bull market phase did not resume ahead of the recovery in the market for corporate debt. Furthermore, it wasn’t until interest rates, in this case the Federal Funds rate, were either at or very near their respective cycle lows that equity markets picked up. While the corporate debt markets led the way, this proved to be more a necessary than a sufficient condition for a sustainable recovery in equity markets.
History tends to be repeated. If another US recession is on the cards - and increasingly this the view - the experience from two previous recessions suggests not only that the spreads have further to widen but also that the corporate bond market is just half to two-thirds of the way through the likely adjustment. That can’t be good for equities!
What complicates the view on the fundamentals for equity markets is the overwhelming influence the financials are having on the downturn in earnings shown in the chart on the preceding page. This is easiest to illustrate for the US, where over 80 percent of companies have reported their fourth quarter results for last year.
According to the tally from Thomson Financial, earnings for the S&P 500 have fallen on a year-on-year basis by around 2 percent. However, it is more than noteworthy that earnings for the S&P 500 ex the financials have grown by over 12 percent. It is understating it to say that this is good going! Yet such has been the obsession with the esoteric, the exotic and the toxic that hardly a word has been said about, what is still, a quite decent performance from at least two thirds, if not more, of the companies in the S&P 500.
We think it unlikely that an earnings recession will become widespread and that corporate America will be forced into a major retrenchment reminiscent of the recessions of the early 1990s and the new millennium. There are three reasons for saying this.
First, in gearing policy to mitigate the disinflationary, if not deflationary, forces of economic contraction, the Fed is cutting interest rates aggressively and will no doubt continue to do so. Mortgage rates have fallen sharply since last summer by virtue of the drop in government bond yields. This could stimulate mortgage refinancings.
Second, the President has now signed into law a fiscal stimulus package providing rebates to US taxpayers and various investment incentives to companies. The package equates to around 1.2 percent of GDP. The rebates should start coming through by May.
Third, although financial leadership still rests with Wall Street, economic leadership has been shifting to emerging Asia, where economic growth has been supporting global growth. An illustration of this is provided in the chart below which shows that the share of exports from the US directed to China has trebled this decade, while that from the eurozone and the UK have nearly doubled.
Although trivial, this positive contribution to growth in the West is not only growing but also reflects the strength of domestic demand in accounting for growth in emerging Asia - and notably China’s growth. Decoupling is happening! The pro-growth policies of an economy like China mean that, if anything, there is a ‘recoupling’ underway. Moreover, the appreciation of a currency like the Renminbi only serves to secure this recoupling.
Indeed, there is an irony in the way developing Asia has started bank rolling growth in the West. Asia’s sovereign wealth funds are taking stakes in commercial banks and private equity and, in time, they may even hoover up some of the better quality distressed corporate debt. Or buy a monoline?
It seems doubtful that a material recession is on the cards for the US economy and that corporate earnings will collapse across the board. While the credit crisis is likely to remain a troubling feature for some time to come, we think corporate bond markets are taking much of this on board and reflect the risks attached to the outlook.
We do not think the S&P 500, the FTSE 100 or the DJ Euro Stoxx indices will follow Japan in retracing 50 percent of the bull market gain. It is probably right to be buying Japan, though better still, right to be buying the value on offer in the UK equity market. A few examples of the leaders, taken from the Oversold Situations for Long Term Recovery segment of our UK action list, include British Airways, Marks & Spencer, Persimmon, Yell, Royal Bank of Scotland and Land Securities. So where to for the FTSE 100? We think 6000 and beyond, not 5000 or less.
In the early days of the subprime fallout, the discussion was all about the re-pricing of risk. Seven months later, this continues to drive the wedge into corporate bond markets, thereby widening spreads, raising premiums on credit related instruments and taking equity markets down the dreary path of a bear market. But it’s not worth despairing. The compensation for the tedium of a bear market is the buying opportunities it creates!