Wednesday, September 2, 2009

Navigating the global credit crisis

Business Times - 02 Sep 2009


Coming months are likely to show not only recovery but, in the case of US, accelerating recovery investors have been hoping for


INVESTORS can learn a lot from history. Looking back at the first quarter of 2009, many investors, fretting about the woeful state of the global economy, failed to focus on the things that matter - valuation and the rapid acceleration of global policy momentum. As it turned out, the combination of these factors created the backdrop for the sharp rally in global equities over the past six months.

Looking forward now from the heights that global equity prices have achieved, it is understandable that investors are getting increasingly wary. Admittedly, the valuation case has weakened with the rallies to date. But global policy effectiveness has not waned. Rather, it has begun to shift from the Chinese-led successes of the first half of 2009 to a broader, global story, with US policy achievements, in particular, emerging recently. This leaves the prospect, we believe, for another leg in the global rally in equities that began in March 2009.

Continued momentum in US economic and earnings data in coming weeks, underpinned by US policy momentum of the second quarter, is expected to drive this leg of the rally. Year-to-date, economic recovery momentum has been key to identifying relative outperformers globally. With emerging markets recovering from the 'Great Recession' more quickly than developed markets, economic momentum reflected in data releases has been a focus of market attention in the current rally. Recall, early in the year, news of the US and Chinese economic policy changes that helped set the stage for a bottoming in global markets. With Chinese stimulus coming sooner and more aggressively, unsurprisingly, the MSCI China rose 35 per cent in the first half of 2009, compared with a meagre 5 per cent for MSCI World.

With Chinese policy now stabilising, as Beijing tries to contain rapid year-to-date loan growth, US growth momentum is beginning to benefit from Washington's stimulus efforts of the late-first quarter of 2009. Their effectiveness was most recently seen in the July 2009 expansion of the Institute of Supply Management's New Orders Index, which historically has provided a three to six-month lead to turns in the US economy. Indeed, the most recent reading suggests that investors' concerns about job growth in the United States may begin to be addressed in coming months (see chart), providing further economic support to the earnings drivers that may emerge come October this year.

Looking a bit further ahead, the US third-quarter earnings season likewise looks set to provide support to the market in coming weeks. Indeed, during the rally since March, the US earnings season - the first six weeks of each quarter - was a key driver for market performance. Recall, as the first-quarter earnings season got under way in April, world equities, represented by MSCI World, rallied 18 per cent before stalling in mid-May as the earnings season came to a close. Similarly, as the second-quarter earnings season got under way in July 2009, world equities rallied another 12 per cent up to mid-August, as the season came to a close again. In total, on a compounded basis, the earnings-season rallies accounted for almost two-thirds of the 52 per cent rise in global equities up to Aug 21. With another earnings season quickly coming upon us in October, Tobias Levkovich, Citi's US equity strategist, notes that upward revisions to earnings expectations could continue into the northern autumn, potentially providing a catalyst for the next leg of the rally we have seen since March.

The resumption of US economic growth momentum and positive prospects for US earnings surprises in the third quarter suggest he global economic recovery is starting to transition from one with China as the sole driver to a more balanced US-China model. Indeed, since mid-year, this transition in policy and data has resulted in US equities outperforming their Chinese counterparts, with MSCI US rising 11.5 per cent up to Aug 21, exceeding the 5.7 per cent increase in MSCI China over the same period.

Therefore, although we can appreciate the caution investors are expressing, given that valuations are no longer cheap, expected news flow leads us to believe that caution will not be rewarded by the markets in the coming months. Rather, we encourage investors to manage their risk by managing their exposure within global equities. We expect that Asian equities, even after a near-50 per cent rally year-to-date, as indicated by MSCI Asia ex-Japan, may participate in this next leg. However, unlike the first half of 2009, where they trumped the flattish 5 per cent performance of global equities, we don't believe that they will necessarily lead regional performances as they did in the first semester.

Rather, investors who ignored US equities early in the year may wish to reconsider opportunities provided by this market. However, they should keep in mind that while recovery looks entrenched, the US recovery is expected to come in sub-trend, with GDP growth in the recovery phase falling short of previous cycle peaks. With this in mind, investors may seek to focus on opportunities that continue to under-price even the modest economic recovery we expect.

In this regard, we see opportunities in US and global energy services companies. While global crude prices have rallied from near-production cost at the beginning of the year to above US$70 a barrel recently, Citi analysts are still able to identify stocks where down-cycle price-to-book value multiples remain in place. As a result, even though global book valuations are expected to recover at only a moderate pace, the prospect for price-to-book value multiple expansion leaves an attractive risk-reward outlook for investors looking ahead.

Despite our optimism through to year-end, we must admit that the global recovery story must be strengthened further to sustain the rally into the new year. China, already grappling with rapid loan growth, must moderate its aggressive easing policy of early-2009 and structurally, continue to build its domestic consumer base. As for the US, it needs to transition its economy from a stimulus-led recovery back to a private sector-driven demand story.

On balance, though, while there are certainly concerns on the horizon, news flow over the coming months is expected to show not only recovery but, in the case of the US, accelerating recovery that investors have been hoping for, leaving the balance of risk and reward through year-end still pointed in favour of the reward camp, and creating an opportunity for investors to broaden out their focus from first-half leader emerging markets to include opportunities presented by US markets as well.

The writer is head of investment analysis & advice, wealth management, Asia-Pacific, Citi

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