AMONG the many gloomy predictions for the coming year, what really catches the eye is the one that says the world will end on 21 December 2012. This is, debatably, the prognosis of the Mayan calendar of eschatology. If the world were really to end on that date, one suspects it would come as a relief to some. I, for example, would not then be required to write an outlook for 2013. There’s comfort in small mercies.
For starters, then, I am going to go out on a limb here and predict that the world will not actually end in 2012. Not because I have any particular insight into the likelihood of this happening or not happening. Only because it’s a no downside bet – or, should I say, a no further downside bet. If I’m wrong, at least I won’t be mocked on the trading floor on 22 December 2012.
Before you write this off as too optimistic, let us say that the list of risks for risky assets this year is almost endless. It ranges across political risk, repression risk, debasement risk, liquidation risk, valuation risk, deflation risk, inflation risk…you fill in the blanks.
Against this catalogue of misery, though, are several positives that should not be overlooked, and it is upon these that this article will focus. As an old mentor used to say, if you have a contrarian bone in your body, you have to be smelling blood for the consensus view today, so pervasive has it become.
So, what could possibly go right for risky assets over the next year? We would list the following positives, potential or real:
1 US EXPANSION
The US economy could gain traction and enter an expansion. This would be led by the labour market, which has been showing signs of life lately. If private sector job creation gathered steam, banks may not have to shrink their loan books as much as the consensus expects.
2 CHINA BUOYANT
China may not have a hard landing. Chinese bank stocks and other cyclicals are trading at valuations that suggest that a hard landing is close to inevitable. In our opinion, this is more to do with capital flight out of China than with any reasonable assessment of likely near-term economic conditions. Domestic investors might get interested in Chinese equities again if the authorities were to lower the very high reserve requirement for the big five banks, and this process has already started.
3 GLOBAL EASING
Every major central bank in the world could buy sovereign bonds; a sort of global quantitative easing (QE). This is not as far-fetched as it may sound. The UK is already engaged in QE2. Arguably the three year long term refinancing operation (LTRO) was backdoor QE from the European Central Bank. We expect an even larger LTRO at the end of February, and outright QE some time in the second quarter, on the assumption that growth forecasts fall during the first quarter. Most people expect the Federal Reserve to initiate QE3 sometime in the second quarter. Plus, if the Chinese economy slows much more it can only be a matter of time before a transition-focussed political elite authorises the monetary authorities to ease substantially.
But are risky assets really cheap enough? Sadly, the short answer is no. If you will only buy risky equities when they offer a margin of safety sufficient to tempt the likes of Benjamin Graham (the first proponent of value investing), then you wouldn’t dream of buying the S&P today. Equally, I can’t imagine that Graham would begin to countenance most “risk-free” assets at this juncture. And if we had to guess which assets he would be inclined towards, I’d bet a lot that he’d lean a long way towards risk, and away from safety.
On the best long-term measure of value for equity markets, the Shiller price-earnings (PE) ratio, the S&P 500 trades on a multiple of 21 times, far above the very long run average of 16.5 times. The great equity bull markets have started from a PE of 5-8 times. So the US is far from cheap. Elsewhere, though, value is emerging. Europe now trades on a Shiller PE of 12 times. So at least we can say that if European equities were to fall another 33 per cent to a Shiller PE of 8 times, they would be extremely, once in a lifetime, cheap.
But while we are some way from those mouth-wateringly cheap levels that excite pure value investors at the index level, there is no shortage of very cheap stocks. One measure we watch closely is valuation dispersion – how widely dispersed are single stock valuations – which is a kind of fear gauge. The gap between the 25th and 75th percentile stock ranked on price/book in Europe has narrowed from close to a record in the last quarter of 2011, but is still much wider than average. In other words, the premium that is being paid for safety is wide compared to the discount that is demanded for cyclicality and leverage.
Ben Funnell is chief equity strategist at Man GLG.
THE YEAR AHEAD
1 European financials’ equity should continue to struggle. A consensus view, but given the amount of recapitalisation that we expect, existing equity holders should suffer substantial further dilutions as banking systems are increasingly nationalised across Europe, much as many UK listed banks were after 2008.
2 Against this, one would expect European financial credit to get attractive, on exactly the same basis. As equity is diluted and re-capped, credit starts to look much more appealing.
3 Value stocks should start to be rewarded, as many equities offer substantially better credit risk than government bonds. Value stocks have hugely underperformed (by 11 per cent last year on our measure) and recently hit new post-2008 crisis lows.
4 Equally, structural growth stocks should re-rate. That sounds like having your cake and eating it, but it’s really a barbell, being long extreme value (outside financials) and stable, structural growth. As Morgan Stanley strategists have pointed out, true growth stocks should do very well in what could be an extended range-bound stock market, just as the so-called Nifty Fifty did in the late 60s and early 70s in the US.
5 Avoid certain defensives, notably telecoms, utilities and (currently) pharma. All look cheap, but all in our view, have structural issues that will continue to depress earnings.
6 Finally, trying to guess the level of an equity index twelve months hence seems a more than usually unproductive exercise, so I won’t try. Simply, it is unlikely that we are starting a new breakout into a bull market, but markets will likely follow the direction of growth expectations and growth mini-cycles, while generally remaining range-bound.
It is also highly likely that at some point in the first half of the year it becomes apparent that most, or all major, central banks in the world are about to engage in another round of quantitative easing, and that should promote a rally in risk assets that is not to be missed. Whether it works for the longer term is another matter.