Daily Themes 3 February 2012

Equities offer value over the long term, but turbulence is still on the radar

The recent Long-Term Refinancing Operation (LTRO) from the European Central Bank (ECB), which enabled banks to borrow money at 1% for three years, has restored a degree of confidence in markets and boosted risk assets. Encouragingly, this action has made the ECB the de facto lender of last resort. With another LTRO auction planned for February, the markets are justifiably a lot less jumpy. However, the euro-zone crisis still has the potential to create volatility for risk assets.

Aside from the longer-term challenges of implementing a treaty change that forges a path towards greater fiscal union, there are a number of short-term uncertainties that are likely to keep volatility elevated. The most pressing issue at the moment is the need to agree a deal on privatesector involvement (PSI) in the restructuring of Greek government debt. The deal then needs to be rubberstamped by the ‘troika’ of the EU, IMF and ECB, with an effective deadline of 20 March looming due to a bond refinancing. Failure to meet the deadline would mean Greece was in default, potentially causing contagion throughout the European banking sector.

Other less-immediate concerns include the sharp spike in Portuguese government bond yields, which have reached the same level Greek yields were at last August (see our 18 January Daily Theme on downgrades to euro-zone sovereign ratings). While Portugal doesn’t need to tap the markets for further funding until 2013, unsustainably high yields will become a growing concern. Meanwhile, this year’s French presidential elections may cast doubt on the viability of Europe’s fiscal compact, with socialist opposition leader François Hollande leading incumbent Nicolas Sarkozy by 31% to 25% in recent polls.

With a number of potential event risks having binary outcomes, and particularly given the unpredictability of PSI negotiations and European politics, accurately forecasting market returns is especially difficult. Despite this, scenario analysis can provide a sensible framework from which to quantify potential market outcomes.

Based on such analysis, the following is our assessment of the base-, best- and worst-case scenarios facing the market in 2012.

Base case

Our base-case scenario – where the euro-zone manages to hold together this year while experiencing a mild-to-normal recession – sees fair value for the S&P 500 at around 1300, with a possible trading range of 1170 to 1430. The current level of 1300, therefore, suggests there is still potential upside within our base case. However, within our base-case scenario we expect periods when euro-zone crisis fears flare up and a break-up gets partially priced in, although ultimately avoided. Similar periods last year saw sharp rises in the VIX index of implied volatility in US equities, such as September’s spike to 47. A rise in the VIX to similar levels would imply a potential decline of roughly 10% from current levels and, in our view, could create an opportunity to add exposure to US equities at good value. Aside from the longer-term challenges of implementing European Union (EU) plans for closer fiscal union, there are nearterm uncertainties that could keep volatility elevated.

Worst case

Our worst-case scenario – where there is either a partial or complete break-up of the euro-zone – remains a lowprobability event. However, at 25% probability it is not insignificant. Under this scenario, we would envisage US equities falling close to levels seen in past severe US recessions. In such recessions, prices have tended to fall much quicker than profits, pushing the S&P 500’s price-toearnings (PEs) ratio down as low as 7.9.

Best case

Despite all the uncertainty, however, there is clear potential for positive surprise. Our best-case scenario sees euro-zone break-up fears dissipate and US gross domestic product growing by 2-3%. With credit conditions remaining very accommodative in both the US and Europe, we would expect only a modest recession in Europe. While this is the least likely of our three scenarios (15% probability), should it occur we forecast a modest expansion in S&P 500 PEs combined with 2012 earnings growth of around 13% – at the upper end of the current consensus range. This would push the S&P 500 some 13% higher to breach the psychologically important 1,500 level.

By definition, the most likely outlook remains our base case. However, though remaining cautious on the outlook over one year, for patient long-term investors current valuations suggest that equities represent good value and, as such, should deliver a healthy positive return over multiyear time horizons.

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