Last week, Merrill Lynch sought to reassure investors that leading European banks would weather the credit storm, unscathed.
Now, Karen Olney, Merrill’s head of European equity strategy, is looking “to calm investor worries by offering a fresh perspective” on the issues facing the market:
Are we heading into a genuine financial crisis or a shorter term crisis of confidence? In our view, this will probably be more of a crisis of confidence (with the necessary caveat that disclosure is still pretty weak).
In Merrill’s view, there’s a sound fundamental story behind their optimism:
1. Large caps still have access to cheap money – “Large cap investment grade companies have not been the main beneficiaries of the credit binge — so why should they suffer when it unwinds?”
2. Credit spreads have become divorced from the risk of company defaults – “Company defaults normally go with the cycle. What’s interesting this time is that the spread for sub-investment grade borrowing has ticked up before the defaults have. This suggests its rise is more to do with technicals than underlying defaults.”
3. LBOs should be back in vogue in 2008 – “While it might undergo a pause, LBO activity is not likely to dry up in our view although the game will change. It likely will move into the larger cap arena where credit ratings are often superior and balance sheets less geared…Investment banks are unlikely to turn their backs on leveraged buy-outs. This is a significant revenue generator and reputational risk is too great.”
4. Spreading financial risk makes sense, but transparency needed – “The size of CDO issuance isn’t small, at US $1.2 trillion. Current worries include the fact that we don’t know who holds the assets and we can’t estimate losses
given they are not a homogeneous asset class. While disclosure needs to be improved, we think the concept of spreading the horrors of sub-prime investing globally with a variety of institutions makes sense. Perhaps, when the dust settles we will find that losses haven’t been concentrated enough to leave buyers materially wounded.”
5. Markets have already fallen by €830bn, does this compensate for the hit? – “Confusion about value and the extent of the rot is creating value within the equity markets. But, we can try to put a size on some of the pockets of pain and compare that to the fall in the equity market. Since 16th July, the European equity market has fallen by €830bn. None of the numbers we dig out add up to such a large number, and most are overlapping with each other.
6. There isn’t a liquidity shortfall – “There are still three pockets of liquidity. Emerging market reserves, sovereign funds or pensions run by government bodies and “relocation funds”. According to Richard Bernstein, anecdotal evidence
suggests that relocation funds are being amassed in the US with the hopes of picking up securities with distressed values. Those that can understand these securities will make money from the panic. Citadel recently launched an administration fund aimed at picking up some of the debris. And of course, private equity pots of money have not disappeared.”
7. Profits are still holding up, even as volatility rises – “Markets are in panic mode, but profits are holding up. Consensus EPS growth for 2007E and 2008E continue to be upgraded to 9.0 per cent and 9.1 per cent respectively. This is still above Europe’s 35 year average. Plus, on a global basis our Quant team have noted that: Usually rising volatility is associated with a slowing profit environment. But our work suggests profit growth remains strong, despite rising volatility.”
8. Markets are not expensive – “We could flag many examples of value, but for this note we highlight two. On a cyclically adjusted PE (using 10 year trend earnings), European equity markets are trading bang in line with their 25 year average. [Secondly], on current PEs, equities are almost the cheapest they’ve been (versus bonds) since 1969!”
Despite its upbeat outlook, the investment bank is looking for protection within the equity market, seeking refuge in the healthcare, oil and gas, personal and household, and technology and insurance sectors.