Global equities: A roller-coaster ride

Neil Michael, Head of Quantitative Strategies for SPA ETF, summarizes the outlook for Global Equity Markets: As we are all painfully aware, it has been an extraordinary roller-coaster ride for global equities in the last year, and in the last few weeks in particular.

Equity Market Performance

As the Credit Crisis tightened in September, global equities were down approximately 13%. And on a year to date basis, global equities are down over 25% - well and truly bear market territory.

September Timeline of Events

It’s not surprising that we are seeing such volatility in the equity markets considering the relentless volley of negative financial events that they were subjected to:

1. On Monday 8 Sept we saw the bail out of Fannie Mae and Freddie Mac
2. On Monday 15 Sept we saw the bankruptcy of Lehman Brothers, Merrill Lynch being taken over by BoA, and the downgrade of AIG
3. Tuesday 16 Sept – AIG rescue
4. Wednesday 17 Sept – Ban on Financials short selling
5. Friday 26 Sept – JPM buy Washington Mutual
6. Monday 29 Sept – the coup de gras – House of Representatives reject TARP – Republicans thought it smacked of socialism, and Democrats didn’t think it was fair to use taxpayers money to bail out rich people

Libor Spread and Interbank Lending

So what is the heart of the problem? The heart of the problem is that banks have effectively stopped lending to each other because of a complete breakdown of counterparty risk. Severe stresses in the financial system can be seen in the Libor rate, which is the rate at which banks lend to each other. This normally moves very closely with the Treasury Bill rate. However, in the last few weeks the spread has risen to unprecedented levels.

The reason banks are not lending to each other is because the seriousness of bank losses, bankruptcies and bail-outs has made them fearful that they might not get their money back; also they are concerned that they will need this cash in case depositors make large withdrawals.

What this means is that the supply of credit to the real economy is being choked off: consumers will find it difficult to get mortgages to buy a house or loans to buy a car; and businesses will find it difficult to expand, set-up new businesses or even maintain existing levels of business as consumer demand contracts. Consequently, unemployment and bankruptcies will rise, leading to a vicious downward spiral in economic activity.

The equity markets became so worried about this doomsday scenario that they began to price in a possible depression as opposed to a recession. The only thing that is keeping the financial system alive at the moment is the massive amount of liquidity that the central banks are pumping into the system.

Equity Market Volatility and the Yield Curve

The tightening in the credit crisis has caused equity market volatility to jump to levels not seen since Long Term Capital Management crisis in Oct 1998, 9/11, and the severe market correction of 2002.

There is a close correlation between current equity market volatility and the yield curve 2 years before – so the YC going flat/negative at the end of 2005 correctly forecast current high levels of volatility. But, unfortunately, the high volatility is likely to stay with us for a bit longer.

At least in the US the authorities have reduced rates and the yield curve has inverted. In Europe, however, YCs are still flat, suggesting that volatility is likely to be worse and last longer. They are also the markets where banks are more exposed to more over-valued housing markets which have only just started to correct.

US Unemployment and Industrial Production

The Credit Crisis has spread from Wall Street to Main Street:

Unemployment is rising –unemployment has risen from 4.5% to nearly 6%

On the back of slowing industrial production – Economic activity is likely to continue worsening as economies de-leverage

S&P 500 Earnings Per Share

Slowing economic activity has caused company earnings to decline very significantly. Most of this, however, is due to financials – many other sectors are still doing reasonably well, such as energy, materials and technology – due to cheap dollar. But EPS will continue to deteriorate further as the world economy slows down, as they did during 2002.

US Dividend Yield v 2Yr Bond Yield

On a brighter note, when once the dust settles and earnings stop worsening, on a longer term view equities look cheap, certainly relative to bonds. The dividend yield on DJ is now higher than the yield on US 2 yr bond, and the gap is getting wider. Last time this happened was in 2003, which was followed by a sustained rally in equities.

Oil and the Dollar

US companies are also getting a boost from both a cheap dollar and falling commodity prices. The Dollar trade weighted index is at its cheapest in decades, making exports more competitive and multi-nationals more profitable. The oil price since 1998 has also corrected massively, taking some pressure off corporate and consumer budgets, as well as relieving inflationary pressure and so making it easier for the authorities to reduce interest rates which may be necessary, especially in Europe.

Price to Cash flow Ratio

The last glimmer of light is the fact that on a long term fundamental view, equities are trading on historically low valuations, but this could trade wider if the crisis deepens.

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