Despite the recent falls in equity markets, some further volatility probably lies ahead, as markets price in more realistic levels of corporate earnings.

In the last Investment Perspective, we highlighted that total sub-prime-related write-downs announced by banks had reached levels consistent with even the more pessimistic academic estimates. We saw this as the end of act one of the credit crunch. We thought act two would look more like the reaction to a normal recession, with broad-based earnings disappointments affecting all sectors, not just financials.

These near-term downside risks to equity markets have since begun to crystallise. However, the speed of the decline, especially in some emerging markets, has been surprising. So what changed to make the recent sell-off faster than we expected?.

The Over the past month, central banks in both developed and emerging economies have responded – with either action or rhetoric – to heightened inflation concerns. Central banks in several Asian countries have raised interest rates or sought to bolster their currencies’ value, the European Central Bank has increased rates and the Fed’s latest statement noted that ‘uncertainty about the inflation outlook remains high.’

Expectations of higher interest rates have hit growth forecasts. Meanwhile, the flattening of yield curves has a direct impact on banks’ earnings and their ability to recapitalise themselves through the improved profitability of their traditional ‘borrow short, lend long’ business model.

However, concerns about higher inflation also seem to be being used as shorthand for more general concerns about the resilience of analysts’ forecasts for corporate earnings. Consensus corporate earnings expectations have been  revised down over the past month, but financials remain the only sector of the S&P 500 where earnings are expected to decline during 2008. By contrast, in previous US recessions, earnings have declined in almost all sectors. In addition, heightened inflation concerns increase the uncertainty of future nominal earnings, thus raising the risk premium that investors demand for holding equities. So mid-July, when the US second-quarter earnings season begins, is a potential source of downside surprises.

INVESTMENT REVIEW

• The macro-economic focus has shifted from concerns about growth to building inflationary pressures, as central banks seek to dampen inflation expectations.
• Rising interest rates would adversely affect the growth outlook and, besides, corporate earnings forecasts already looked unrealistically high outside the financials sector.
• We therefore forecast further volatility in the months ahead, as expectations are revised down for both earnings and rate rises.
• Although long-term returns from equities are likely to be rather less strong than in recent years, they should still easily beat cash and bonds.

Financials remain the only sector of the S&P 500 whose earnings are expected to decline in 2008.

These near-term risks and equities’ decline since the market peak last October have brought equities down to levels where they look cheap relative to both bonds and their own past valuations. That is significant, as our work suggests that the single most important variable in determining equity returns over a long-term investment horizon is equity markets’ valuation at the time of the investment.

A valuation-driven model of ten-year returns since 1970 (see graph above) shows that, with a price-to-earnings (PE) ratio of 14.3, current global equity valuations are consistent with average annual returns over the next ten years of 13.3%. Of course, we would caution that corporate earnings are set to decline by more than the current consensus expectations. In other words, current PEs are probably misleadingly low whether judged on past or forecast earnings. Any sustained rise in inflation would  also distort the relationship, as the resultant earnings uncertainty would increase the equity risk premium and so reduce the PE. Encouragingly, there is no sign so far of such a structural change, at least in developed economies.

However, even if we reduce earnings per share (EPS) by the average decline over the past three US recessions, we are left with a PE of 17.8 and expected average annual returns over the next ten years of 10.9%. So, over the coming years, equity returns may be lower than in recent years – though still comfortably beating cash.

These near-term risks have brought equities down to levels where they look cheap relative both to bonds and to their own past valuations.

In other words, current valuations make it highly likely that investors will be rewarded for holding equities. Yet the flip side of these potential long-term returns is near-term risk. Hence, the main factor in asset allocation decisions over the next few months should be investors’ willingness to accept current levels of volatility in return for longer-term excess returns.

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