Lots of Bad News in the Press

30/01/12

Speak to any Fund Manager and they will say that valuations matter most of all. To generate long-term returns investors need to buy financial assets when they are cheap, not when they are expensive. So how much bad news is now in the price? A lot of negative news has broken in recent weeks and should now have been absorbed into the asset prices.

 Here is a top line summary of the recent bad news:

1. At the end of last week Standard & Poor’s downgraded the credit ratings of nine Eurozone (EZ) countries, including stripping France and Austria of their AAA rating and taking Portugal down below investment grade. This leaves only four EZ countries with triple A ratings and, as a result, the European Financial Stability Fund (EFSF) was also subsequently deprived of its AAA rating. According to the German newspaper Die Welt, on the back of this, plans to leverage the (EFSF) to up to EUR1.5trn from EUR440bn “are practically dead.”

2. Negotiations between Greece and representatives of private sector creditors broke down at the end of last week, raising concern that there will be a ‘disorderly’ default rather than a managed debt swap in March when Greece is due to repay EUR14.5bn in bond redemptions. This will be impossible unless Greece gets the frozen 7th tranche of the support package from the so-called ‘troika’ (EC, IMF and ECB) which is itself conditional on closing the debt swap. Such a disorderly default would trigger credit default swap contracts, likely creating a new wave of uncertainty and potential contagion in an environment where it would be extremely difficult to compute the impact on individual banks and insurance companies given the integrated nature of financial markets and institutions. Although negotiations have subsequently resumed agreement has still to be reached and, moreover, investors have also come round to the realisation that even a successful conclusion of negotiations on the terms of a swap would still leave open the question of investor participation and the risk that private creditor ‘holdouts’ are subsequently forced into the deal removing any notion that this is a ‘voluntary’ rather than a coercive swap.

3. In the background, global economic growth expectations have been further downgraded recently and now recession in 2012 is the central forecast for the EZ. The World Bank is indicative of the trend: it now believes that the EZ entered recession in Q411 and sees a 0.3% contraction in the bloc’s GDP this year. It has also lowered its US GDP growth forecast to 2.2% in 2012 from 2.9% previously and expects world GDP growth to fall to 2.5% in 2012, down from a forecast for 3.6% growth six months ago. According to the Bank, emerging countries should take steps to plan for a global economic crisis in line with 2008/09 if the EZ Sovereign debt crisis intensifies.

4. Corporate earnings expectations have been downgraded but in spite of this the Q411 US earnings season that began last month has generally been disappointing. According to Bloomberg, in releases thus far fewer S&P 500 companies have beaten analyst earnings expectations than at any time over the last 4 years.

5. China has not been immune from the gloom. GDP growth has decelerated with Q4 growth slowing to 8.9%, the lowest growth rate for ten quarters, increasing concerns about a hard landing in the world’s second largest economy. Property prices in China have also been under downward pressure which continued into December when residential property prices fell more than at any point in the previous 12 months and new home sales fell month-on-month in 52 of 70 cities monitored, adding to concerns that this could have a debilitating effect on the domestic banking system.

 But look through the gloom and focus on valuations

Clearly, this is a substantial raft of bad news to hit the market in a relatively short period of time. But the limited reaction of markets to these events and data releases suggests that it was largely already factored into asset prices. In fact, global equity markets are up year-to-date and most risk assets and currencies have fared reasonably well so far this year in spite of the negative news flow.

Additional evidence that investor expectations have been driven sharply down by negative news is provided by the so-called activity ‘surprise’ indices for the US and the EZ. In both cases the data across a broad range of indicators has generally been coming in better than expected recently, in large measure because expectations have been trashed to such an extent. This is in sharp contrast to the six month period to end September 2011 when the data for the US surprised negatively, a factor that was instrumental in the market selling off over that period. Things could always get worse than currently expected but the negative tone of recent news suggests that there is a lot of angst already factored into asset prices.

In fact, the correlated 2011 sell-off in most risk assets has also created long-term value in a range of fundamentally attractive investments, given that it was based more on risk aversion than deterioration in underlying fundamentals.

In bond markets there would be a preference for corporate over safe haven developed world government bonds. The latter look expensive on fundamentals while companies generally have strong balance sheets, are in many cases cash rich and offer an attractive spread over treasuries and other safe haven government bonds. For the most part, the corporate spread widening in 2011 is not credit specific but a reflection of an absence of risk appetite.

Equity markets are also generally trading cheap to their longer-term valuation averages on a forward PE basis despite, in some cases, big downgrades in earnings forecasts. Not surprisingly, the EZ is the region where there has been the most aggressive downward revisions – by close to 80% on average since June. Most emerging markets earnings growth estimates have also been revised down. For example, earnings estimates for the Indian market have been cut by almost 50% since last June. Moreover, both developed and emerging markets equities look cheap relative to history. For many, emerging and developed markets look appealing and this may be an attractive entry point for exposure to powerful long-term investment themes like emerging consumption and infrastructure spending.

So, if you are in it for the long-term, now could be the right time to get back into the market – although, in the right asset classes, of course. It might be an idea to take a look at an Absolute Return Fund – from the likes of Hendersons.