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Risk aversion rising

By Michael Preiss

20 July, 2011

Recent equity market weakness seems to have caught some investors by surprise. The end of QE2 on June 30, as outlined in a previous column here, has significant implications for global financial markets that investors ignore at their peril.

The month of June saw declines in most asset classes. Stocks, bonds and commodities posted monthly declines for the first time since the end of the financial crisis in February 2009, dragged down by concern that Greece will default and signs that economies are slowing.

While Greece's approval of budget cuts and tax increases last week, which were were required to win bailout funds, drove the biggest four-day rally in the MSCI index since December, it failed to erase June's equity losses. Riskier assets fell last month as US economic reports missed projections by the most since January 2009.

The Standard & Poor's 500 ended 1H2011 with 5% returns after flirting with a break of the 200-day moving average yearly trend line and almost going into negative territory for the year, only to be saved by the Greek bailout.

YTD, Greece is almost bankrupt but its equity market is only down 9.5%. European politicians are "kicking the can further down the road", postponing but not avoiding the inevitable painful restructuring. Postponing the inevitable only makes it worse. But then again, often a politician is someone who bribes you with your own money.

The way of least resistance, it seems, is to create more problems and moral hanzards down the road and let future generations carry the burden. It seems that European leaders have learnt this bad habit from our friends in Washionton.

The clock is ticking for the US to avert a debt default. Come Aug 2, the US will face a default on its debt if Congress fail to raise the US$14.3 trillion (RM43 trillion) debt ceiling. But Congress will first need to pass a deficit-reduction package before it signs off on lifting the debt cap, which has been anything but easy.

US lawmakers have been unable to reach a consensus, with the Republicans and Democrats sharply divided over spending cuts and tax hikes. The Republicans are demanding more spending cuts and opposing tax hikes before they agree to any deal. Congress and the White House have made the markets and myself a bit uneasy lately with continued partisan bickering and insistence by key Republicans to link spending cuts or other measures to the vote. President Barack Obama's hardline rebuttal, where he accused the Republicans of trying to secure tax breaks for the rich, only increased this uneasiness.

The US debt ceiling stand-off is going to be a game of chicken to the end because the conventional wisdom is that "cooler heads will prevail".

What happens if nobody flinches? That is the story that will dominate markets this month.

The third quarter usually brings with it low volume and low volatility and a market that goes basically nowhere as everyone, from investors to the US Congress, enjoys the final two months of the summer and then take their time getting back to business in September. This quarter will be different.

It is entirely possible that the end of the second round of quantitative easing (QE2) will mean a higher US dollar and a negative for the S&P500, which derives 40% of its earnings from outside the US.

This scenario would be a negative for a stock market that has doubled from its post-Lehman low in March 2009, a higher dollar, a peak in operating margins, a slowdown in EPS growth, a rise in volatility and risk premiums that are inevitable in the post-QE2 financial markets.

There is growing concern that corporate earnings estimates will have to be revised sharply downwards. It will only become clear in autumn whether the global economy can pick itself up after the "soft patch" in growth. Hence, the 2Q earnings season could be one of the most interesting in years with an increasing number of analysts questioning the outlook for corporate profits.

Will the rally in the stock market continue in 2H2011? The outlook for corporate earnings could be less favourable than many assume. Profit margins have risen significantly since the end of the recession but the scope for a further rise could be limited at this stage of the business cycle. Following a string of weak economic reports in the quarter, analysts have slashed their expectations of more than a third of the S&P 500 companies over the last four weeks.

Valuations increasingly also look stretched. On a 2011 price-earnings ratio estimate of 14, the market seems reasonably valued. However at 22.7, the cyclically adjusted PER of the S&P 500 is well above its long-run average since 1900 of just below 15. Of course, there is no reason why equities cannot become even more overvalued when real interest rates are negative.

However, I think investor appetite for risk in 2H2011 is less likely to wax than to wane.

The bullish argument is that stocks are a buy as the cash-rich corporate sector in the US is set to be a net buyer of equities. Both cash-financed M&A activity and buybacks could be the driver of equities in 2H2011. Investment spending intentions and US business confidence survey suggest a pickup in M&A, which tend to lag the stock market buy a year.

My view of US equities, However, remains "neutral". It is difficult for me to turn positive on the S&P 500 despite the market U-turn last week.

The S&P 500 has now fallen for two months, albeit on low volumes, an erratic spike in volatility and no real capitulation selling.

The macro headline risk in the world is still grim (China, Greece, the US budget deficit, banking contagion, soft PMI worldwide) and the fate of Oracle after its earnings report suggests technology risk is still an issue. Even Ben Bernanke has now admitted that economies and asset prices (houses, shares) can remain low for many years after the collapse of a speculative credit/property credit spiral.

This is something that macro horror stories from the past - the debt deflation that followed the October 1929 Great Crash, the sovereign default of Latin America the Turkey, the Asian and Russian currency meltdowns in the 1990s and the Japan Nikkei crash - suggest.

Even the US$8 trillion rise in the stock market cannot offset the cumulative impact of 14 million Americans unemployed, a US$1.5 trillion Uncle Sam budget deficit and one-third of US homeowners with negative equity (underwater mortgages where the value of a house is far lower than the money borrowed to buy it)

Michael Preiss is chief equity strategist at

Standard Chartered Bank