Here’s Morgan Stanley’s take on 2009.
In a nutshell, the UK equity research team says we’re not out of the woods yet. Key observations include yet more profit and dividend declines, and the fact that traditional metrics won’t necessarily work anymore - balance sheets preferable over p&ls.
Their overview states:
2009 is likely to be another testing year for equity investors given a difficult macro outlook. We expect UK profits to fall by one-third in this cycle and dividends to contract by 15-20%. We would advise investors to continue to practice patience. Our 12-month FTSE100 target is 4300.
Equities look cheap — but bear case implies 40% potential downside. Traditional valuation metrics suggest equities are very cheap and are, arguably, pricing in as much as a 50% drop in earnings. However, the fragility of the financial and macro backdrop may continue to suppress risk appetite. If investors choose to apply a trough multiple on trough earnings, we think there could be 30-40% more downside to stocks.
Stock picks for 2009. We identify seven buy ideas for 2009: Autonomy, BP, Cadbury, Carnival, Pearson, Rentokil and Vodafone. Our seven sell ideas for 2009 are: British Land, Drax, Enterprise Inns, HSBC, Smith & Nephew, Stagecoach and Tesco.
How does that compare to the team’s forecast for 2008? Well this time last year they were saying:
Under our base case scenario we set a FTSE100 target
of 6300 for December 2008. However, we believe the
risks around this forecast are to the downside and set a
‘bear case’ target of 5350.
Hmmm, not so good. Although, to their credit, they did foresee the emergence of major UK budgetary problems:
As our prime minister has been so fond of telling us, the UK economy has enjoyed a record 15 years of economic growth. However, instead of using this golden period to bolster savings and prepare for leaner times ahead, the public sector is in deficit (unlike the years preceding 1990/91 and 2001/02). In reality, Exhibits 1 — 3 highlight that the government, households and banks have all been guilty of stretching the elasticity of their balance sheets — in effect, betting on the absence of an economic cycle.
In this year’s outlook, fiscal concerns remain a worry with the key risk, according to MS, being an outright loss of fiscal faith in the UK (the economy, government and sterling).
We fear that, if the ongoing monetary and fiscal stimuli fail to arrest the decline in the domestic economy by the middle of next year, investors may begin to lose faith in the UK.
Consequently, a significant rise in the UK’s cost of capital (higher gilt yields) and/or a further large devaluation of sterling could have very serious ramifications given the government’s need to borrow nearly £500 billion in the gilt market over the next five years to fund both investment and consumption.
According to MS, the key measure to track on this will be sterling vs sovereign CDS. As can be seen below, it already shows investors turning disturbingly fearful.
Back to 2009: while MS sees earnings falling by around one-third, they’re also expecting the downturn won’t be worse than the average of previous recessions. Fat tails, however, are getting fatter, as results from varying metrics are continuing to deflect to an ever greater degree. This can be seen in the sharp difference between the bank’s bull, base and bear scenarios:
One of the points we are trying to make by highlighting such a variety of valuation metrics is that the range of possible outcomes for the equity market remains very wide right now. In such a situation we think our bull, base and bear case framework is a useful tool to aid in scenario analysis. Under this framework our base case forecast for the FTSE100 in 12 months’ time is 4800, with a bull case of 6500 and a bear case of 2500. If we were to assign probabilities to these three outcomes we would argue for 45% for the base case, 35% for the bear case and 20% for the bull case, to reflect our view that the risks to our base case are to the downside. Probability weighting our various index targets gives us an overall forecast of 4300 for the FTSE100 at the end of 2009.
Indicators that will determine which scenario unfolds are changes in:
* Credit availability
* Money supply
* Leading indicators* Earnings revisions
In the meantime, MS says the deteriorating macro backdrop will continue to favour defensives over the next six months, although, they say, PEs are already looking very stretched on a relative basis. While there’s no surprise that defensives are expensive and that financials and cyclicals are cheap, they note some other interesting sector trends too:
1) Utilities and Food & Beverages are the most expensive defensive sectors — they trade at an all-time high valuation relative to the market and their Shiller-type valuations are close to their long-run average (in contrast to all other sectors that are significantly below). Telecoms is the most attractively
valued defensive sector, particularly on a dividend yield basis.
2) Within the cyclical universe we favour consumer-facing names over industrials, as they should benefit from aggressive rate cuts, have ‘earlier cycle’ characteristics and trade on lower valuations. Commodity-related sector valuations have fallen significantly, but the sectors are still not particularly cheap when viewed on a dividend basis.
In conclusion, although the bank expects the market to reward large-cap companies with strong balance sheets and reliable growth prospects - the key investment decision in 2009 will be when to start to selling defensives and buying cyclicals and financials.
