The recent pullback in the market has led to another bout of soul-searching among investors. Is the global recovery a fake? What will be the shape of the recovery—will it be V, W, U, L or a more exotic symbol (some have suggested a square root, others a sine wave)? Is China a bubble? Have stocks run up too fast?
Let’s start with the fundamentals. As pointed out by many economists and the International Monetary Fund, a recovery from a credit bust usually takes years. Sure, the government can help cushion the impact by fiscal and monetary expansion as it has done so far. The impact, seen from the Purchasing Managers’ Index data, is that manufacturing has bottomed out globally and services are close to levelling off.
But there are plenty of reasons for the Western economies to continue to remain sluggish. Here are a few: banks have yet to write off a lot of their toxic assets; debt as a percentage of the US household income is still very high; US consumption remains very weak; foreclosures in the US continue to mount. But as analysts have pointed out, when Newsweek magazine’s cover story says recovery will be sluggish, it’s safe to assume that everybody knows the recovery will be sluggish. Analysts will remain bearish about the markets, producing earnings estimates that can be easily beaten, as happened with the US earnings in the last quarter.
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In short, the widespread expectation of a slow recovery will keep the door open for positive surprises. That should be true for local concerns about the monsoon as well. When fears of impending drought have made it to the front pages of newspapers, the markets should already be factoring that into account. Most economists have revised their gross domestic product estimates downwards.
True, valuations are stretched. But a Nomura India note on investment strategy says that the consensus is currently pricing in earnings growth of 7% for the companies in the Sensex index this year, which is low. It points out that the view that sales growth has been sluggish in the June quarter is incorrect—for the BSE 100 companies on the Bombay Stock Exchange, other than banks and oil and gas firms, net sales were up 20% year-on-year. The conclusion: “Even under a bearish scenario that FY10 profit margin is lower by 100 bp (basis points) than the 1QFY10 profit margin floor of 16.4%, we could still end up with 26% earnings growth. This implies that the one-year forward P/E multiple for Sensex could actually currently be in the range of 12.5x-13.0x compared with 15.5x based on consensus earnings.”
The point is not whether Nomura is too bullish, but whether low earnings expectations will allow companies to beat expectations, as happened during the June quarter.
Citigroup researchers have called a period of falling earnings accompanied by higher stock prices a “twilight zone” and say this happens at the initial stages of a recovery, when macro lead indicators start flashing green while analysts are still too uncertain to revise their forecasts. For example, they point out that “the early 1990s saw the longest twilight zone. Global equities bottomed in October 1990, a full 33 months before the turn in the earnings cycle”. It’s possible that we are at present just coming out of such a twilight zone.
What drives the disconnect between earnings and prices? In one word—liquidity. The US Federal Reserve has given ample indications that it will continue to support liquidity, because the recovery is weak.
A research note by Deutsche Bank concludes that “given accelerating global excess liquidity creation, it may only be a matter of time until investors become increasingly unwilling to hold liquidity at the current low level of return. Once investors try to reduce their liquidity holdings, asset prices may again receive a temporary boost from global excess liquidity”.
The China scare is actually a liquidity scare, with investors worried that the slowdown in lending will lead to less money flowing into their stock markets and the Chinese central bank reportedly setting the stage for tighter monetary policy. But as Morgan Stanley’s Manoj Pradhan points out, albeit in a global context, “Monetary tightening is likely to be weaker than markets currently anticipate. Having worked so hard to engineer a recovery, it is difficult to see why central banks would aggressively tighten policy, risking a strong adverse reaction from markets and putting the fragile medium-term outlook in jeopardy”.
And Credit Suisse analysts Nilesh Jasani and Arya Sen write: “Commodity and certain emerging market ETFs (exchange-traded funds) have effectively replaced IT or banking stocks as the primary momentum securities for developed world retail investors in recent quarters”.
So to answer those questions: Yes, the recovery is dicey in the sense that it’s so far dependent on government stimulus; the recovery is unlikely to be V-shaped except in the short term; stocks have run up too fast; and yes, China is a bubble in the sense that it constituted one leg of the global imbalance and since the US consumer leg of the imbalance is correcting, the other leg will have to follow suit, unless it changes to a more domestic demand-oriented policy.
On the other hand, there’s also a lot of liquidity. The Credit Suisse note points out that ETF flows are “macro-driven and momentum-fuelled”, making the markets more volatile. The great global reflation trade will continue as long as governments and central banks can support it.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org