Four reasons it is not all about Europe, says Investec’s Max King
The market low seen in early October did not represent the capitulation of sentiment sought by contrarian investors as a true market turning point, but there was plenty to suggest that bearishness was exaggerated.
1) Fears of a US recession were partly the result of disappointing data, partly of the assumption that the market sell-off in August was a leading economic indicator.
However, broad money supply and bank lending to businesses have been growing steadily since early 2010, both important pre-conditions for growth. Business and consumer surveys were gloomy but hard economic data much less so.
It should have been no surprise that third quarter annualised growth has been estimated at 2.5%, with more expected in the fourth quarter. While economic prospects in the distressed countries of the eurozone remain dismal, growth is also likely to pick up in the UK, where excessive pessimism is rife.
2) It is not yet proving to be a problem for companies that economic growth is likely to remain sluggish. US nominal GDP has risen 3.5% to 4% in the last year but third quarter revenue growth for the S&P 500, on the basis of the 65% that have reported, is over 12% higher than a year ago.
Growth may be lethargic, but it is focused on the areas which are beneficial to companies, rather than on government spending and credit expansion. Companies are also benefitting from the increasing importance of exports and revenues of overseas subsidiaries.
Companies should be able to continue to grow revenues considerably faster than nominal GDP, and earnings even faster. The same is likely throughout developed markets.
3) Global earnings forecasts have been fading but still point to low-teens increases for both 2011 and 2012, according to consensus forecasts at mid month. With 2011 nearly over, the scope for further downgrades is very limited. The danger that attractive multiples are undermined by falling earnings is remote.
At the market low, equities were trading on below 11 times 2011 earnings and below 10 times 2012 earnings, way below historic averages or any reasonable estimate of fair value.
On a prospective basis, equities were cheaper than they were at the March 2009 market low, when sharp falls in earnings were expected and subsequently experienced. In contrast, spreads on investment grade and high yield bonds, though attractive, were well below their 2008-2009 crisis highs.
4) Europe ex UK accounts for about 16% of the MSCI All Countries index. Excluding the non-eurozone countries of Scandinavia and Switzerland reduces the figure by a few percent and North Europe is hardly stressed. That means that less than 10% of global equities are in stressed markets; on an economic basis it is about the same.
However severe the problems of 10% of the global economy and markets are, they are not enough, by themselves, to derail global prospects. For that, the fears prevalent in August of a Lehman-like banking collapse in Europe, spreading contagion around the world, would have to be valid.
The consequences of the collapse of Lehman make it unlikely that arguments for imposing moral hazard on the banks would hold any sway, in our view. We think the bailout of Dexia further reduces the probability of a significant insolvency being allowed to unfold.
What now for investors?
It is inevitable the eurozone crisis will continue to dominate markets. It did not prevent a market rally and markets should, in the medium term, be able to grind erratically higher without a resolution.
The banking problems are a long way from being recognised and quantified, let alone resolved, and will continue to undermine global markets. While it was right to add to equity exposure in early October, it is likely to prove prudent to reduce exposure into strength.
Investors who missed the rally are likely to get another chance.
Max King is a strategist and portfolio manager on Investec’s multi-asset investment team