Coordinated cuts

By Mike Lenhoff 16:48 31- Oct -2008

With few exceptions, monetary policy is now geared to mitigating the severity of the downturn in the cycle.

Yesterday the Fed cut 50 bps off the Funds rate. Next week the Bank of England and the European Central Bank will likely cut interest rates by at least half a point. The Bank of Japan may even re-introduce the zero interest rate policy it had in place between the spring of 1999 and June 2006.

As the chart shows, not only are interest rates coming down but they are coming down in the developing economies as well as in the developed economies. Yesterday, China cut interest rates again. The People’s Bank of China cut for the first time in mid September, then cut them for a second time the day following the round of cuts by the major central banks earlier this month and have now cut for a third time. India cut interest rates by a full one percentage point at the beginning of last week. At the start of this week, the Bank of Korea cut rates. Overnight the Hong Kong Monetary Authority followed the Fed’s half point cut with a half point cut of its own and Taiwan’s central bank lowered interest rates too.

Now that’s coordination! In the same way that intervention by governments is attempting to address a market failure - i.e., the failure of the financial system which lost its capacity to function - here is a show of like-mindedness from the central banks which recognise the urgency in bringing interest rates down. The developed and developing economies are all moving in the same direction and fast - the former are in recession and the latter are losing rapidly the momentum underlying growth.

The downturn in the cycle has become increasingly evident in corporate earnings. In the US, where the third quarter reporting season is underway, the numbers are coming in far worse than expected. At the start of July, analysts expected earnings to grow by 12.6 percent for the third quarter, according to Thomson Reuters. By the end of September the consensus expectation had been revised down to -2.9 percent. Now, with over 60 percent of the companies in the S&P 500 having reported, the running tally for earnings growth (based on a combination of reported and estimated numbers) is around -24 percent. Earnings are disappointing in most sectors but the poor third quarter result is due in large measure to the financial and consumer discretionary sectors, where earnings are still falling well short of expectations.

By the end of this reporting round earnings will have been declining on a year-on-year basis for five consecutive quarters. As the chart below shows, this is a length comparable to the earnings recession associated with the dot com bust but, given the difficulties that lie ahead for the global economy, the likelihood is that this earnings recession will now extend over a longer period.

On the other hand, it is also likely that equity markets are discounting a lot of the bad news to come. They have given up 80 percent of the gain in equity markets between the spring of 2003 and the summer of 2007.

Equity markets are discounting a severe recession. As the chart below shows, prospective p/e ratios for both the major and emerging equity markets are lower than at any time in the period for which the series exists. If one looks at trailing p/e ratios, these are back to levels last seen in the early 1980s, a time of one of the worst recessions on record in the post war period.

Equity markets offer value for the long term investor. In addition, and with few exceptions, interest rates are now being (or about to be) cut in earnest. The major central banks are continuing to provide liquidity through their lending facilities and the Federal Reserve is continuing to introduce new facilities. Government policies aimed at recapitalizing the banks and guaranteeing the issuance of short to medium term debt have helped to stop the financial system from slipping over the ledge into the abyss. Indeed, they have helped move it some way back from the abyss judging by the developments in the interbank markets. This is encouraging.

While equity markets are no longer quite as oversold as they were earlier in the month, they are still oversold as my chart below shows for the UK. In a recent note (And now the recession – that equity markets are discounting 10 October 2008), I commented that, following the extreme oversold condition earlier this month, we could be in for a snappy rebound to a level equity markets may be content to trade at until there is some clarity of vision on the way out of recession.

I didn’t specify any level but as of last night’s close the FTSE 100 and the other major equity markets had already rallied by some 10 percent from this Monday’s closing low. I had in mind a little bit more than that since a 15 to 20 percent rebound is not an unusual reaction to an extreme oversold condition. Let’ see where we get to on this one. The volatility in equity markets has yet to diminish. No doubt we’ll be stuck with it for some while but it would be great if we could see a bit more of it on the upside!

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