Global equity market valuations look very compelling from a long term perspective...but too many question marks remain on Banks, Financials, Real Estate, not to forget Oil.
## But it is still too early to call the bottom in equity markets,,,
## ,,,given continued uncertainties about the macro landscape and persistent credit and financial sector risks.
## Where oil heads next will also be important for stocks $149/bl is still expected.
## Euroland PMIs and US jobless claims on the calendar today.
1. Market overview
It was a relatively uneventful day in the market with the SPX eventually closing up 60bps. The financials sector ended its 2-day losing streak after the WSJ reported that Freddie officials were meeting with the Treasury to discuss a federal bailout.
On the data calendar today, the US jobless claims will be of focus. Despite a slight decline in the most recent report on new claims, both new and continuing claims are substantially higher than just a few weeks ago. If the Congressional extension of jobless benefits has pushed these numbers higher, we should see a meaningful decline in the next week or two; otherwise, we will interpret this as further fundamental deterioration in the labour market.
Growth news outside the US will also be key to our view that the US Dollar has bottomed. In that regard, the Euroland flash PMIs for August will be important to watch today.
2. 50% of the world economy facing recessionary conditions. Our current macro views suggest that the US, Japan, Euroland, and the UK are either in recession or face significant recession risks in the months ahead. To put this into perspective, these developed economies account for about 50% of the world economy (based on their PPP weights).
Recently Jim O'Neill suggested that the probability of a world recession - defined as global GDP growth of about 2.5% - is about 15-20%. As we have discussed before, given its importance to world growth in recent years, a world recession would in all likelihood involve a hard landing in China. Despite the latest bounce, Chinese equities (and other assets such as copper and commodity equities) have traded recently as if China may be slowing somewhat.
But our lead indicators and still accommodative Chinese financial conditions suggest a small probability of a hard landing: our current forecasts show 10.1% and 9.5% GDP growth for 2008 and 2009 respectively; we are slightly above consensus expectations for growth this year and next.
Continued robust, albeit slowing, growth in China and the rest of the emerging markets is a major driver of our view that the world economy will grow by a healthy 3.6% next year after 3.9% in 2008 (on a PPP basis, the emerging markets account for the other 50% of the world economy).
3. Global equity valuations look attractive for long-term investors,,, While the economic outlook in the US and non-US OECD remains weak, from a longer-term perspective global equity valuations look very compelling.
As Salman Ahmed described in Tuesday's Daily, EM equities now enjoy a sizeable valuation gap versus developed market equities (the current valuation gap is not very far away from the levels seen in late 1998). Even on an absolute basis, however, developed equity markets like Europe and the US clearly have valuation support.
In Europe, the current forward P/E is just 10.5x, close to the lows of the early 1990s. According to our European strategists implied growth analysis, the current valuation implies just 50bp of earnings growth each year for the next five years (see Supporting valuation, Strategy Matters, 26 June 2008).
In other words, an investor is paying very little for any future upside growth currently, and the only other times implied growth fell to these levels was in late 2002 and early 2005, both proving to be good buying opportunities.
The US equity market also looks inexpensive on a forward P/E basis. Currently, the S&P 500 is trading at 12.9x forward earnings, a level not seen since September 1995 and well below the 20-year historical average of 15.6x and long term peak of 15.7x. Our US Portfolio Strategy team's implied growth analysis shows that current valuations imply only 1% earnings growth per year over the next five years.
This is in stark contrast to the 10-year historical average of 18% implied earnings growth for the S&P 500 and suggests that the market is undervaluing future earnings growth
(see the US Daily overnight which discusses why a potential second fiscal package is unlikely to have any impact before 2Q 2009).
4. ,,,but still too early to call the bottom-The valuation metrics suggest that investors with a longer term investment horizon could now see global equities as a good buying opportunity.
But arguably valuations have been compelling for a while and there are a number of factors that suggest it still might be premature to call the bottom in equity markets:
First, given that the global equity markets have already adjusted to a less optimistic view of the macro environment, it would probably take materially bad news to spook the markets. Even so, investors might still want further confirmation that the market has priced enough downside macro risk and that: 1/ China (and EM in general) is experiencing only a gradual slowdown in the face of a broader OECD downturn; and 2/ the recent stabilization in US growth is genuine especially in the face of mounting pressure on the US consumer (given that the fiscal stimulus is fading and that the housing and labour markets continue to show signs of deterioration).
Second, earning expectations still need to be revised lower. For instance, while analysts 2008 European earnings estimates have been revised down 9% since the start of this year, consensus earnings growth forecasts of +1% (2008) and +12% (2009) still appear too high given the margin and volume pressures firms may face.
Our strategists expect earnings to fall 6% this year and 5% in 2009 - but while below consensus this is a less severe downturn than in the early 1990s or 2001-03. With regard to US Financials, our analysts are continuing to slash earnings estimates and push out
the "bottom" into Q1 2009. Subprime risk is now rolling into prime mortgages and the commercial real estate market is starting to show signs of real weakness - these two new risk areas could prolong the Financials crisis and put continued downward pressure at the index level.
Third, the two-month high reached in Libor spreads earlier this week suggests that the banking sector is likely to remain under pressure. Perceptions of credit risk also remain elevated judging by the five-year interest rate swap spread - the premium charged over Treasury yields to exchange floating for fixed-rate payments - which is approaching the 110-120 bp all-time high levels it reached just before the SIV rescues in November last year and the Bear Stearns collapse in March.
Our credit strategists also continue to see credit spreads widening from here as credit quality worsens, ratings downgrades pick up and default losses increase.
Fourth, our Commodity Research team still expects oil to rebound to $149 over the next few months especially as the recent data suggest that oil supply growth remains weak and non-OECD oil demand, particularly from China, is still strong. If this forecast is anywhere near the mark, a renewed surge in oil prices could once again fuel inflation concerns and limit the upside for equity markets.
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