- Companies' robust financial health, net exports and further rate cuts by the Fed are keeping the US from slipping into recession.
- Investors are keeping the faith in equities, although treading more cautiously, with regional biases (pro-Asia, Turkey and Russia) and sector biases (pro-energy, financials, pharmaceuticals & utilities)
2007 was a turbulent year in the financial markets. Time and time again, they were swept by fears that problems with securitised subprime mortgages (and the associated credit crunch anxiety), the malaise in the housing market and diminishing job creation in the US, or expensive oil would put an end to the worldwide economic boom. Equity markets nevertheless held up quite well, and index losses were fairly limited. Brussels and Tokyo proved to be the main exceptions. Probably, already cheap share prices helped keep prices from falling further. Fluctuating market sentiment about where the economy was headed also prompted sharp movements in bond rates. The fact that they fluctuated more in the US than in Europe was no accident, with the dollar falling to new historic lows.
A crisis that came in waves
The crisis swept through the market in three stages. Initially (February-March), there was a sharp correction when it became clear that problems in the US housing market had increased the number of borrowers defaulting on mortgage loans, particularly in the so-called subprime segment, where many loans had been securitised. In a second stage (July-August), the lack of confidence brought about by these structured loans caused liquidity on their secondary market to dry up, which in turn undermined the value of a good many credit portfolios. However, fears that there would be a general 'credit crunch' were alleviated to some extent by the Fed's no-nonsense approach (massive cash injections and a cut in interest rates). When third quarter earnings releases started to come out (in the latter half of October), the crisis reached its third stage. The market is currently focusing on identifying the market players that have been hardest hit and determining how vulnerable they really are. Any lack of clarity or failure to make full disclosure has been punished mercilessly, while transparency has in certain cases been rewarded. Markets are still in this third stage. Less than a quarter of the loan losses have been traced. With a few exceptions, only banks have reported subprime-related loan losses, and while there is no doubt that they will have been hardest hit, they are certainly not the only ones affected. Some of the securitised loans have been sold on to other investors, which means there will be loan losses in other sectors too. Consequently, there's enough fuel to fan the flames of unrest for a while to come.
Recession remains at bay
The subprime crisis has lasted for six months now, and the malaise in the US housing market for a good two years. Neither the one nor the other has had any serious impact on the rest of the economy. We consider the subprime crisis to be a temporary problem in the financial industry, but certainly not a serious threat to the US economy. Both subprime and prime mortgage loans account for only part of the overall credit market. The level of provisioning for the total credit portfolio is still low from an historical perspective. The crisis of confidence is one amongst financial institutions themselves. At the moment, the subprime issue is keeping the spotlight off a number of other risks, although these pose just as much of a threat to the US economy. We are referring primarily to the deteriorating labour market outlook and the soaring price of oil. Indeed, the petrol price trend is affecting consumer confidence and the uncertain labour market prospects are starting to depress consumer spending growth.
However, we expect that the financial health of the business sector, net exports (thanks in part to sustained strong growth worldwide) and further rate cuts by the Fed will keep the US from slipping into recession. In the months ahead, the central banks will focus on growth rather than on inflation. And, while inflation may have risen over the past few months to near or above the ceilings the Fed and the ECB consider desirable, this inflationary pressure will not mount significantly any time soon in view of the slower growth that lies ahead, especially since we feel that the oil price will start heading down in the months to come. In the US, a key rate of 4.00% (4.50% today) is on the cards. The ECB has not changed its key rate over the past few turbulent months. Consequently, we expect that it will remain on the sidelines in the next twelve months too. If it does act, it will probably cut rates following a possible worsening of the economic statistics. By mid-2008, when the liquidity crisis and fears about growth have abated, bond rates can start anticipating new rate hikes and begin heading up again.
Investors keep the faith in equities, but tread more cautiously
In each of the years from 2003 to 2006, the price trend on the equities markets could be accounted for almost exactly by the (explosive) growth in company earnings and, to a much less extent, by the trend in interest rates. In 2007, the (positive) trend in company earnings and interest rates parted ways with the (negative) trend in share prices. The bad news that markets have already discounted in share prices is excessive. To cite one example, the market value banks lost (around 600 billion USD in the US and Europe combined) was a multiple of the potential loan losses (estimated at 170 billion USD). The undervaluation of US and European markets has therefore increased. Once the turbulence in the financial markets dissipates and equity markets realise that the subprime crisis is not heralding the bankruptcy of the financial system, they will be able to derive energy from the macroeconomic superstructure.
In our equity portfolios, we are focusing specifically on Southeast Asia, Turkey and Russia. Asia is the growth pole at the moment, and the region boasts a sound economy. Moreover, stock markets there have a price/earnings ratio of around 16 times earnings for 2008. This is not more than in the US and certainly justified for growth markets. In Turkey and Russia, markets are extremely cheap, with a price/earnings ratio of 11. Other positive factors are that many Turkish companies are speeding up their restructuring efforts and that Turkish macroeconomic policy is clearly aimed at eliminating imbalances. In Russia, the imbalances have already been cleared up (there is both a budget and a balance of payments surplus). As regards allocation across industry sectors, our bias is towards companies achieving structural growth throughout the cycle that are attractively priced (pharmaceutical & financial shares). For the rest, we are riding the wave of consolidation and picking up dividend yields (utilities & financials). With oil prices remaining high (despite the anticipated decline in oil prices) energy shares also retain their appeal. We are also taking advantage of this segment specifically via equities in the alternative energy sector and in Russian companies (Russian oil conglomerates are trading at a discount of 25 to 30% compared to their peers in the West).
For more information :
- Luc Van Heden, Chief Strategist
KBC Asset Management
02/429.59.77 - firstname.lastname@example.org
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