We live in remarkable times. Corporate earnings have never been higher. Yet, sovereign bond yields have never been lower. In the past, anyone who would have predicted these record breaking developments to occur at the same time would have been carried away in a straitjacket. After all, the first event points to a healthy business environment, the second points to deflation and/or recession. The unfortunate events preceding this bizarre outcome caused investors to sell equities, making them look decisively cheap. Have markets overreacted? Are equities a bargain?
At the moment, equity markets are pricing in about a fifty percent probability of a recession in the Western world and zero percent earnings growth for 2012. With German Bunds and US Treasuries yielding less than 2%, bond investors appear even more certain that a recession is coming. At the other end of the spectrum, equity analysts are still frustratingly slow in picking up the message the markets are giving them. They are reducing their forecasts but still expect global corporate earnings to rise by more than 10% in 2012. In other words, they expect continued healthy economic growth. If they are right, equities are a screaming buy. We think they are wrong.
The eternal positivism of equity analysts may still prove to be justified, but that would require an immediate end to political bickering on both sides of the Atlantic. Currently, it appears very unlikely that investors will get the clarity about future fiscal policy they so desire, certainly in the Eurozone. “Muddling through” seems to be the key word and, perversely enough, the ultra low bond yields in the core countries help to remove the required sense of urgency. Meanwhile, this “muddling-through-policy” gradually paralyzes the banking system, which in turn puts a brake on economic growth as a whole.
We see an increasing risk that the Western economy will face negligible or even negative growth in 2012 and that corporate earnings will mirror that development. In that case equities are not as cheap as they appear. For example, the current valuation of equities is still more than 20% higher than during the trough of the previous bear market, although it has to be said that corporate balance sheets are now stronger than at the start of the 2008/2009 recession. More simply put, equities still have about 20% downside in case we enter a recession . . . and have about 20% upside in case we can clearly avoid one.
Meanwhile, the different sectors within the equity market show a wide range of risk/ reward ratio’s. Financial companies, still the biggest sector, have become very much geared to political decision making. They appear very cheap on traditional fundamental yardsticks but will keep showing massive price fluctuations in response to sovereign policy decisions rather than management decisions. Cyclical companies have been hammered in the recent sell-off, but still do not fully price in a recession. In this segment we prefer the commodity producers, since they are more exposed to emerging market growth than Western growth. In the defensive arena, which we still like best, we see internationally exposed food and beverage producers and pharma companies as best positioned, more so than the domestically exposed utilities and telecoms.
Overall, we still maintain a somewhat cautious stance towards equities, although we recognize that the valuation is becoming more attractive. As long as the US and the Eurozone postpone decisive fiscal action, they will keep paralyzing the banking system and the economy. Equity markets are clearly giving a signal. We hope that policy makers will act on it.
