Analysts' optimism looks overdone

Even though the US looks set for recession, due to the deflating housing bubble and tighter credit conditions, Wall Street is unfazed, says Kopin Tan in Barron's.

A poll of 12 US strategists reveals a consensus forecast for a 10% gain in the S&P 500 index in 2008. They expect the US to avoid a recession, with global growth supporting the domestic economy, and lower interest rates to bolster profits and equities.

Here, a poll of fund managers by Investment Week shows predictions for the FTSE 100 ranging from 6,400, slightly above the present level, to 7,386.

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But given the current backdrop, these forecasts look optimistic. Over the past few days equities have been on the slide again following five central banks' barrage of measures to thaw the frozen money markets.

These added to concerns that "the scope of problems in the financial sector and the global economy could be wider than feared", says Neil Dennis in the FT. The moves included extending the maturity of central bank money, making more available and broadening the range of collateral against which banks can borrow, all with a view to easing high one-month and three-month interbank rates.

This week, the European Central Bank offered a rare guaranteed rate well below the market rate and unlimited funds on two-week loans. It ended up injecting almost double the anticipated amount of liquidity into the market e349bn a number which highlights that Europe's banks are hoarding cash "to an extraordinary degree... and begs questions as to whether banks know something nasty the rest of us do not", notes Gillian Tett in the FT. The move brought some relief to the two-week interbank rate, which fell by 0.5%.

But overall, the banks' measures have produced only a "slight thaw" in money and credit markets", as Michael Saunders of Citigroup points out. Three-month sterling rates, for instance, are down from 6.6% to 6.4%, but still far higher above the base rate than usual.

No wonder. The fundamental reason why banks are loath to lend to each other is the uncertainty over the extent of subprime-related losses on balance sheets and thus the solvency of banks in the system.

In these circumstances central banks can make liquidity available "until they are blue in the face", as Roger Bootle puts it in The Daily Telegraph, but it doesn't change the fundamental problem of falling asset values after a bubble bursts.

The fear-induced squeeze is unlikely to ease soon, given estimates of losses on mortgages in the hundreds of billions (with more to come as the US housing market worsens), of which banks have written down just $80bn. Central banks can't end the credit-market stress, and they can't prevent it "causing a significant economic slowdown", says the FT.

With banks less willing or able to lend, credit availability falls. Scarcer credit means less money for business expansion, and with consumers also ailing, earnings prospects beyond the banking sector (set to drop by 7%-10% in the fourth quarter in the UK, according to HSBC) are fast clouding over.

And the mining sector, which has propped up the FTSE 100 as banks, indices and sectors more exposed to the domestic economy have been hit, could come under pressure as global growth eases.

In all, with growth set to slow sharply and Dresdner Kleinwort pencilling in a 50% chance of a recession, analysts' expectations of 8% earnings growth from UK companies next year, up from 4.7% in 2007, look unrealistic. If the estimates were right, the market wouldn't look too dear on a p/e of 12, says Ian Campbell on Breakingviews. "But shares are likely to follow estimates, and the economy, downwards."

The same goes for the US economy, where the prospect of continual rate cuts has receded amid mounting inflationary pressure. Nor should investors take decoupling for granted, as we noted last week. Given all this, it's hard to believe strategists will be this sanguine in 12 months' time.