Is a recession priced in?
Unlike the 2009 crisis, which caught majority of the investors by surprise and had significant contagion effects, as financial institutions were highly leveraged and bankruptcies of Lehman, BST and GE sent volatility to sky-high levels.
During the current global environment, policy makers seem to be ready with the policy tools in case of a double dip recession, though they are left with little fiscal and monetary space as compared to the beginning of the crisis. For instance, the exhausted fiscal stimulus for the US and already low interest rates.
Euro zone economic turmoil seems far from being resolved with Greece on the verge of defaulting on its foreign debt. This leaves little room for European banks, which are relatively undercapitalized and are likely to require an additional 200 to 300 billion euros to meet Basel-III requirements. UK on the other hand is in talks to approve another round of quantitative easing, worth £75 billion to stimulate its economy.
In times of increasing volatility, correlation between global financial markets has generally increased in the past, with no exceptions from Global Emerging Markets (GEMs). This has provided various investment opportunities in the recovery phase as emerging equity markets hit their peak post 2009 recession, outperforming majority of the developed markets. Though it may be hard to envisage whether markets have hit their 2011 lows or not, it would be useful to analyze market/country based on its own merits rather than lumping them altogether.
According to Citi’s estimates, GEMs earnings are set to grow at 16 percent in 2011 and 12 percent in 2012. This compares with the developed markets average earnings growth of 10-12 percent. Significant portion of the global GDP growth is to come from the GEMs; currently about 40 percent of global GDP, with China having a lion’s share. Given the weak economic environment, fortunately, Chinese policymakers have sufficient fiscal and monetary space to counter a slowdown perpetuated by Europe.
China being a key growth engine for the world also has relatively low dependence on Europe. In 2010, only two countries (Germany and Italy) from euro zone made it in the top 10 Chinese exports by destination and together accounted for only 8.2 percent of the total Chinese exports, thus posing limited downside risk to Chinese trade balance in case of a recession in euro zone. Emerging markets on the average are down 35 percent from 2011 peak levels and down 22 percent YTD at the end of 3rd quarter, as represented by MSCI World Index.
With European financials down 30 percent, markets seem to be pricing in a quarter or two of negative GDP growth. In wake of the financial turmoil, majority of the financial markets have been hit hard, in particular, the GEMs, which trade at 8.7x forward and 10.2x trailing earnings. As per the Economic Cycle Research Institute (ECRI), the US economy has already entered a new recession and it is going to get a lot worse.
Since the beginning of this year, developed markets have seen outflows of $60 billion, with the largest outflows of $58 billion from US alone. This may provide some opportunity to the GEMs, which may see a fresh flight of capital, as GEMs seem to be pricing in 24-32 percent earnings downgrades according to Citi’s estimates. Even if there is an earnings contraction of 42 percent, which was the case in 2009, multiples would rise to 12-13x, justifying fair valuation as historically GEMs have traded at such multiples.
Year-to-date dedicated emerging market equities have seen outflows of $40.1 billion as compared to the $49.3 billion outflows seen in 2008. With the situation not as bad as it seems, it can be argued that equities have become attractive and may see inflows toward the end of 2011. Unlike the situation of 2009, average cash holdings of mutual funds according to a survey conducted by Merrill Lynch stood close to 5 percent in September. Allocation to fixed income remained high on lower appetite for risk. In an event of further downside, valuations are likely to become further attractive providing meaningful upside potential to equities. With positive set of news flow coming in from Europe in the likes of recapitalization of banks, further stimulus and austerity measures, short term sector switching from defensive into the cyclical seems to be gradually picking up pace.
The US chemicals sector gaining 7-10 percent over the week is an example of the impact on the equities once risk taking by investors return to a normal level. GEMs have traded only six times in the past 192 months, (or just 3 percent of the time) at a lower trailing multiple than the current levels. With a lot of negative news already priced into equities in the short-term, markets may witness some rally toward the year-end on positive news flow from euro zone and earnings surprise, however, long-term challenges remain intact, which may require additional structural reforms and revival of consumer confidence in the developed markets, which remain subdued as we enter into a prolonged phase of low growth.
Khurram Javed, CFA, is an associate at Morgan Stanley Investment Management-MSIM in Saudi Arabia