Fundamentals are uncertain and risky, but because inflation is not yet a real problem, rates are flexible and can stabilize the growth outlook, eventually. And remember, if things get less bad, that would be good enough for markets to go higher.
Global growth prospects seem good. Dr KOSPI, Dr Copper and Dr Baltic Dry, all those market barometers of the growth outlook who deserve the title of Dr because of their PhD in economics, are voting with their feet and telling us the global growth outlook is intact and good.
US slowdown. This rosy picture for global growth is in contrast with some of the US-based indicators, which indicate slowing growth. Our US economist Richard Berner expected 1.9% GDP growth in 2007, down from 2.9% in 2006, and 2.6% in 2008 the last time he released his forecasts, in early August.
Soft decoupling is the norm. A US slowdown, provided it is not a severe slowdown, doesn’t usually affect the rest of the world too much. A recent study by the IMF shows this point very nicely. Whenever the US GDP growth deceleration from one calendar year to the next is less than 2 percentage points, the rest of the world has been unaffected historically. Whenever the slowdown has exceeded 2 percentage points, the deceleration in the rest of the world has been very pronounced.
Currently our US economists expect a deceleration of 1%-point in 2007, far below the threshold. In addition, many emerging market specialists, including Stephen Jen and Jonathan Garner, are effectively arguing that the US matters less now than it has in the past, which implies the 2%-point deceleration threshold may even be higher now.
Europe should whether this storm well. In two recent pieces by our European economists they explain that house prices are at similarly stretched levels in Europe as in the US, but the European consumer is in much less precarious situation because its savings rate is high and the subprime market is absent outside the UK (See How Susceptible Is European Housing to US Problems? by David Miles, August 30, 2007). Furthermore, in examining the transmission channels through trade links, credit tightening and house prices, they conclude that the euro area should prove relatively resilient. Within countries, Spain appears to be the most exposed to tighter credit conditions, and Germany is most sensitive to a possible slowdown in global trade (see How Could the US Disease Infect Europe? by Eric Chaney, August 30, 2007).
Core inflation has been easing. The unemployment rate in the US, for instance, at 4.6%, is still some way above the low in 2000 when 3.8% started to create inflationary pressures, and the Fed fund rate reached 6.50%. In a more globalised world the US unemployment rate probably needs to go even lower than that before inflationary pressures are triggered. As long as inflation is not a big problem, rates can act as automatic stabilizers to the growth outlook and ‘solve’ the growth problem, as they have done for years now, time and time again.
Insiders have been buying, and that is bullish. At the end of August we reached the lowest insider selling / buying ratio since the end of 2002.
Quant model says we aren’t heading for a recession. Our quant model to forecast recessions tells us that we are 4 Fed rate hikes away from a recession. And remember, this model has predicted each recession since 1960, and has never given a false signal. The recent peak in this indicator at 50% at the beginning of April was significantly below the 70% threshold below which there has never been a recession. Remember, we use this as a binary indicator: below 70% there has never been a recession, above 70% there has always been one.
European earnings outlook good. We expect 9.0% EPS growth in 2007 and 6.5% in 2008, compared to IBES consensus expectations of 8.9% and 9.8%. We also recently introduced a quant model to forecast earnings for the next 12 months, our EGLI or European Earnings Growth Leading Indicator, in An Earnings Growth Leading Indicator for Europe, June 25, 2007). It takes into account five factors: US earnings growth, ISM New Orders, BNB Business Survey, German 10yr bond yield and Fed Funds target rate. It currently forecasts 17% growth, suggesting that there may actually be upside risks to our forecasts. Our take on this is that we will see downgrades in the next 6 months, in all likelihood, especially among Financials, but as long as EPS growth is positive a mid-cycle slowdown environment is bullish for equities through lower
rates.
Credit valuations are more reasonable now. In Sanity Check, May 23, 2007, we published a chart showing how irrational credit markets were. Credit markets were priced such that the weighted average cost of capital (WACC) gets lower with more debt, irrespective of how much debt a company has. Thus, a junk bond rating of BB gives companies the lowest WACC. In other words, no cyclicality of cash flows was priced in, illustrating excessive risk appetite. By now, the optimal point on the credit curve is BBB, followed by A, which is a much more stable situation. The investor we met in May who stated that February 2007 is to credit what March 2000 was to the NASDAQ shared a brilliant insight with us!
Authorities are reacting: central banks are injecting liquidity, and President Bush has announced some measures. We are moving through the usual sequence of events in a crisis. The end of such a crisis is when authorities step in to try to solve the problem. We are well into that phase. With core inflation having eased, there is room for more rate cuts, and they may indeed be needed to stabilize the outlook. Government Sponsored Entities may have to be allowed to inject liquidity and buy up some of the derivatives that are in trouble before a more stable situation in money and credit markets is restored. Ben Bernanke clearly illustrated he is aware of the severity of the situation in his recent Jackson Hole speech.
Many short-term worries. The appetite for LBOs and structured product certainly peaked in Q2. There is a large pipeline of leveraged loans to be placed (~US$500 billion according to Monday’s Financial Times), which hangs over credit market valuations. Real estate is overvalued everywhere. The Anglo-Saxon consumer will slow down. More financial losses will be uncovered — watch in particular the investment banks reporting. Money markets are severely dislocated still, and it is important that they stabilize indeed in the next few weeks, as we expect. Having said that, wages and employment growth are still good, companies have very strong balance sheets, and there is a lot of money around, looking to invest in public equity markets, or in distressed debt markets, including among the new and rapidly growing sovereign wealth funds and uninvested private equity.
Continued…