The writer returned from his trip to the Caribbean a day or so ago to be confronted with another swathe of dramatic headlines amongst the financial pages of the nation's press. Whilst it is tempting to think that many of the risks to the financial markets analysed in earlier Week In Preview publications had come together to form the basis for a disorderly melt-down, in fact, things are considerably less gloomy (in the near-term at least) than market action might have us believe.
US Treasury Secretary Mr Hank Paulson (who already has his hands full in attempting to force the Chinese authorities to give the "green light" to an end to the currency peg) was quoted in an interview on CNBC television as saying that the US mortgage lending and general leveraged buy-out markets had been driven by speculative excesses in recent years and that the latest price action represented a reassessment of these risks and consequent financial market adjustment.
Well surprise, surprise! In point of fact, whilst contagion fears relating to both have been around for quite a while and are to some extent already priced in by a wary market, what appears to have been forgotten is that companies have continued to deliver earnings ahead of expectations over the Q2 reporting season and, perhaps more importantly for the future, the futures market has launched itself off the fence and now anticipates a 95% chance that the Federal Reserve will cut its Fed Funds Rate by the end of the year, a move likely to presage a massive bull steepener bond yield curve.
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The European Q2 Reporting Season Thus Far
Obsessing over widening credit spreads and a higher oil price (the latter a reflection of existing supply concerns, coupled with the arrival of the peak hurricane season in the Caribbean and Gulf of Mexico), investors appear to have forgotten that one of the key drivers to equity market sentiment remains the trend in analyst earnings revisions and the subsequent ability of companies to meet or exceeded those altered expectations. The latest aggregation of Q2 2007 data paints a very positive picture across Europe (including the UK). To date around two thirds of those companies reporting have exceed consensus Q2 earnings expectations by more than 5%, while just 19% have missed expectations.
By sector, the strongest positives have come out of the Oil & Gas sector (average +13%) and Technology (+10%) while the median positive surprise is 8.1% across all sectors. In the context of a Q2 reporting season which has, historically, thrown up the greatest dispersion of surprises, both positive and negative, results so far have gone very well indeed.
For reference, the US reporting season has gone equally well. With 65% of S&P 500 companies having reported, almost 50% of those have delivered positive earnings surprises in excess of one standard deviation while only 12% of those companies so far reporting have missed expectations. Median growth in earnings over Q2 is currently running at around 9% against expectations for c4% ahead of the season. Returning to Europe, investors might like to note that over July 2007 and 2008 earnings expectations were revised up by 1.0% and 1.2% respectively. The latest upgrades now assume that European equities deliver 8.0% earnings growth this year and 9.3% next. The clear divergence between equity market pricing and corporate earnings experience suggests that the latest bout of equity market volatility will, once again, be used as an opportunity by long-term investors to pick up favoured stocks more cheaply.
The Federal Reserve Goes Into Action?
As mentioned, the financial futures market has worked itself into a frenzy in the wake of the latest swathe of bad news emanating from the US residential property market and credit markets. Operators are now forecasting a 95% chance of a US base rate cut before the end of the year (from 32% one week ago). It seems that investors are not yet ready to jettison the so-called "Greenspan Put". We sense they may be right. Bear in mind that the US 2-year note continues to trade at the same level it was at on 3rd January 2001, the day that, belatedly, the Greenspan Fed finally woke up to the then 40% collapse in the Nasdaq index as the heat evaporated from the dot.com bubble and cut rates by a full 1% point. Although the tone of recent Fed statements and that of a number of regional Fed governors has been hawkish, so it was in the wake of the November 2000 meeting at which point concerns regarding possible inflationary pressure emanating from a tight labour market were still very much in evidence.
Thus we suggest that investors would be advised not to read too much into recent communiqus and that unlike its European Central Bank, Bank of Japan and Bank of England counterparts, it has a reputation for moving base rates between meetings if conditions warrant. On this occasion, although rhetoric has been hawkish we would point out that core inflation is already below the level it stood at in January 2001 (and is now falling further), the unemployment rate is higher than six years ago and economic activity is weaker. Turning to the personality differences between Greenspan and Bernanke we think that just because the latter has presided over a now year long pause in monetary policy, that he will necessarily continue to preside over the status quo. Bernanke is, after all, the author of the book "Essays On The Great Depression" and should be well aware of the appropriate policy action to take in the event that activity doesn't remain at Q2 2007 levels for long.
By contrast, Greenspan, for all his plaudits, hung fire throughout the Russian default and Asian crisis of 1997 98 and failed to act in timely fashion to prevent a disorderly bursting of the dot.com balloon in 2000. The past few weeks have set Dr Bernanke an important test. Should the Fed continue to be more worried about skilled labour shortages, or the oil price, or spiralling raw material prices generally, or should it begin to think in terms of rising investor pessimism, financial market volatility and its possibly adverse impact on real economic activity levels?
Most significantly, research shows that when the income required to service the high and rising level of debt created both in residential property and the credit markets becomes insufficient, the inevitable consequence of rising interest costs and falling asset prices is increased investor risk aversion, rising financial market volatility and an increase in the probability of financial market shake-outs from time to time.
Housing is a critical lead indicator in the US and Bernanke knows it. He is recently quoted as saying that rising delinquencies are creating personal economic and social distress for many homeowners and communities and that the problem is likely to get worse before it gets better! The bad news for Dr Bernanke and his coterie on the Open Markets Committee is that research by his own Fed staff indicates that more than 60% of the US housing market bubble was down to the availability of cheap credit and less than 40% to low interest rates. Hawks might argue that cutting base rates in such circumstances is little more than pushing mightily on a string, but which central banker would want to be caught fiddling while Rome burned? Better, in the face of a growing economic crisis to be seen to be doing something rather than nothing in our view.
Whilst some investors might be wringing their hands and wishing that they had sold in May we are more sanguine. To some readers, familiar with the periodic bursts of pathological bearishness apparent in this article, these two important reasons to be cheerful might indicate that the writer's recent close encounter with a reef shark might have been sufficient to persuade him that life's too short for immersing one's self in the global economy's long-term structural problems. Rest assured, those structural issues persist and are likely, from time to time, to exert a significant impact on financial market activities, but for the time being the confluence of corporate financial strength and the likelihood of US monetary policy easing should go some way towards reassuring those jangling nerve ends.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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