Market Review 27 September 2011

How ironic – the new, decisive action rumoured to have been hashed out by the eurozone at this weekend’s G20 summit involves leveraging up the 440 billion euros in the European Financial Stability Facility (EFSF) to over 1 trillion euros in order to relieve the debt strains of its peripheral members. Twelve zeros!

According to the BBC’s economics correspondent Paul Mason, a euro crisis “war game” organised by the BRUEGEL think tank just over a week ago “saved” the euro -kept Greece, Ireland and Portugal in the eurozone- and postponed the region’s structural problems to be addressed another day. They did it by boosting the EFSF’s 440bn with matched funding from the IMF, leveraging that to over 2 trillion euros, and then having the ECB issue debt with future European tax revenues as collateral.

The total 3.7 trillion euro war chest allowed them to relieve European banks and countries who were struggling to borrow. Citizens of Europe, great news, your politicians and technocrats have postponed the day of structural reckoning and have mortgaged away your future.

July’s original version of the EFSF itself is still in the process of being authorised by the region’s governments. Remember July’s bail out? No need, there’s another one to replace it. The rumours around the G20 also suggest an acceptance by the eurozone that a Greek debt “restructuring” is inevitable, with a 50% haircut now mooted to replace the voluntary 20% agreed as part of the previous “decisive” and “final” solution. This time the non-eurozone members of the G20 appear to have urged action, with the next G20 meeting in November flagged as a final deadline.

Last week the global markets gave the G20 a hefty shove to remind them of the consequences of eurozone disorder, particularly bank failures. After a cheery rally the week before in anticipation of the United States’ FOMC meeting, the announcement of the widely flagged Operation Twist seriously underwhelmed market, although the long end of the yield curve duly declined.

Equities and commodities suffered last week. MSCI’s All Countries World Index was down each day, ending down on the week by 5.4% in sterling, and closed Friday down 11.7% for September to date. Europe ex-UK was quite weak, but Asia Pacific ex Japan fared worst, down 8.2% in sterling. Developed markets (down 4.7%) did much better than emerging markets (down 9.7%), where Brazil fell 12.3%, China 9.3% and Russia 14%. Gold was down over 9%, silver nearly 18% and oil (West Texas) down 7%. Bonds were once again on the front foot, with the US 10 year yield down to 1.84% and the 30 year down to 2.9% from 3.3% the week before.

Whilst fear of systemic problems clearly stalks markets, the lubricant of growth is also steadily seeping away. Everywhere economic forecasters are cutting their GDP forecasts for the developed economies, with ISI reducing their real US GDP forecast to 1% for the next three quarters. All this is now emerging in brokers’ earnings forecasts, which have been revised down over the past month by 3.6% for the year ahead, with downward revisions of 8% in Europe ex-UK.

This uncertainty over immediate future profits has left equity markets on historically low valuations. The world including emerging markets trades on just under ten times next year’s profits, with the UK on eight times and offering a historic dividend yield of just over 4%, compared with the 2.2% yield on the 10 year gilt. Even the US, according to MSCI, offers a dividend yield of 2.2%, 40bps above the 10 year Treasury.

Valuation can be a dangerous and elusive siren luring equity investors on to dangerous rocks, but it is also, with hindsight, always the source of the great trough to peak returns enjoyed by equity investors. What is a share of a company’s profits worth? The answer is always unhelpful. It is worth the discounted future stream of expected profits. But it is also worth whatever the marginal buyer is willing to pay. As always at times of great uncertainty, stock markets are hostage to the struggle for these to find a balance.

Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton