Finding the silver lining
Despite higher volatility, largely reflecting financial market stability concerns and
expectations for a US recession, there is reason for optimism in global equity
markets. Monetary and fiscal policy response has been aggressive and more is
likely on the way. Thus, a major source of ‘tail’ risk appears to have been removed.
Coupled with attractive valuations, low interest rates, and reasonable earnings
growth, we believe prospects for a more sustainable rally in equities appear good.
Broad market support
Sectors that underperform in a sell-off also tend to recover the most. Thus, we add
to positions Financials and Consumer Discretionary. Even so, we believe a decline
in risk premiums is likely to provide a boost to market valuations making a broadbased
recovery. To reflect this more outlook we trim our defensive exposure
(Healthcare and Consumer Staples), which we upgraded in January.
Regions and stocks
We retain our regional allocations, where we are overweight in the US, neutral in
GEM and Japan, and underweight Europe and UK. We are making several changes
to our Global Top 40 stock list: Adding: Prudential Financial, News Corp,
Barclays, and BNP Paribas. We are removing State Street, Sumitomo Mitsui
Financial, BAT, and Novartis.
We recognize that a move to become less defensive could still be early given that
uncertainty could persist. Details of policy response are still unknown and global
growth is still under pressure, which may keep earnings expectations muted.
Volatility in financial markets has continued to ratchet higher in recent weeks.
With expectations for a US recession still on the rise and concerns about the
stability of the financial system acute, markets have reeled amid the uncertainty.
The collapse and buy-out of Bear Stearns over the last several days was the most
recent source of uncertainty and anxiety for markets to grapple with.
Yet, despite all of the angst, perhaps there is a silver lining. While fundamental
pressures on the US economy stemming from the decline in house prices persist,
the policy reaction to financial market turmoil has become increasingly
aggressive, particularly from the Federal Reserve. To be sure, response has been
necessary. Credit markets are under strain, banks have been under associated
stress, and pressures have seemed unlikely to abate on their own. But, the
nearing of a potential ‘bailout’ suggests that more of the current crisis is behind
us than ahead. This does not imply that the days of worry and volatility are
things of the past. It does, however, suggest that the uncertainty that has
depressed overall equity market valuations is likely to dissipate, leading to a
more sustainable rally than has appeared probable in recent months. Thus, we
are getting ready for a shift in markets to a more positive assessment of nearterm
prospects based on the policy response we’ve seen so far and what may yet
In this report we outline our expectations for global equity markets in coming
weeks and months and look at historical sector and regional performance in a
recovery. We present a summary of work done by our Global Banks team that
looks back at a history of bailouts of the banking system to provide some
context about where we stand in today’s environment. We also look at prospects
for the sustainability of a rally given the underlying macro environment. Finally,
we address our current regional and sector allocations. Our conclusions follow:
Expectations for the arrival of concerted policy response should help to
alleviate pressures on the financial system and result in a broad equity
market rally. Indeed, a reduction of risk premiums is likely and will help
boost overall valuations which have room to rise materially.
Past examples of banking system bailouts should offer hope to investors.
Performance of domestic bank stocks following inception of a banking sector
bailout is usually robust, with an average gain of nearly 30% in three months.
The historical pattern of a market rebound suggests that the sectors that have
been under the most pressure also rebound the most. Therefore, we have
lifted our allocation to Financials and Consumer Discretionary. A long-term
sustainable rally in these sectors will require signs of more sustainable
growth potential. In that vein, challenges will persist. For consumers, balance
sheet repair is still needed. Meanwhile, financials face continued questions
about growth potential in coming years given shrinking balance sheets.
The rally in stocks we envisage is more about falling risk premiums (rising
multiples) than about a change in fundamental expectations. Therefore, we
are trimming our exposure to defensive sectors which we upgraded in January.
In particular, we are trimming Consumer Staples and Healthcare to
Neutral. We retain overweight positions in Technology and Telecoms.
Regionally, we are keeping our current recommendations unchanged. We
remain overweight in the US, neutral in Global Emerging Markets and Japan,
and underweight in Europe and the UK.
We are making several changes to our Global Top 40 stock list. We add
Prudential Financial, News Corp, BNP Paribas, and Barclays. We remove
State Street, Sumitomo Mitsui Financial Group, BAT UK, and Novartis.
We recognize that a move to get less defensive still could be somewhat early.
Uncertainty may linger for the financial sector and for the equity market as a
whole as details about further policy action are debated. Moreover, overall
economic conditions remain challenging and recession in the US appears
probable. To that end, sustainability of overall earnings growth may remain a
concern. This suggests that a prolonged rally requires signs that a slowing in
US growth will be relatively short-lived and mild. For financials, long-term
growth prospects for the sector will continue to be questioned.
Policy response, fundamentals and valuations
Actions already taken by the Federal Reserve over the last nine months in
response to the housing and financial market crisis have been significant. Those
actions include cuts of 300 bps in the Fed Funds rate and 375 bps in the
Discount Rate since August, creation of the Term Auction Facility (TAF), Term
Securities Lending Facility (TSLF), Primary Dealer Credit Facility (PDCF), and
involvement in term-funding of Bear Stearns. In addition to monetary policy
measures, there has also been fiscal action, with a tax rebate approved by
Further, we believe that there’s a probability of additional measures that will be
taken by Congress and, perhaps, the Fed to provide more stimulus and liquidity
to the economy and to markets. The combination of these measures should act as
a stabilizer against the instabilities caused by the weakness in the housing
market. Our Global Banks strategy team has compiled a history of banking
system bailouts that compare similarly to the current environment. They also
show how markets have performed in periods following bailouts. In short, when
policy is implemented, markets tend to respond positively. We provide a brief
summary of their findings on page 6.While not reason, alone, to become positive
on the outlook for equities, we believe policy action will be successful.
Therefore, coupled with other positive factors, equities appear oversold.
As we have highlighted often in recent months, absolute valuations on global
equities are attractive. Current market levels are consistent with ‘trough’
valuations coupled with near-trough earnings. To that end, value exists in
markets, and there’s considerable scope for multiple expansion without
threatening aggressive valuation levels. Moreover, multiples can expand against
a backdrop of slowing earnings growth.
Low levels of nominal and real interest rates also favour equity markets. Real
interest rates (the real Fed funds rate is now negative) are supportive of overall
equity market valuations. Moreover, the low level of interest rates has resulted
in continued rise in the equity risk premium (Chart 3 and Chart 4). Of course,
interest rates have been low for some time and have favoured equities. But, a
shift in sentiment and decline in uncertainty will allow for risk premiums to fall
and, hence, equity multiples for the market to rise.
Markets are likely to require reasonable earnings growth to sustain a rally
beyond short-term short covering that is driven by expectations for policy relief.
While we continue to believe that earnings growth is slowing globally and that
bottom-up estimates for this year remain somewhat optimistic (particularly in
emerging markets), though there have been downgrades to earnings estimates in
recent months. At the same time there are other sources of support. As we have
highlighted regularly, the health of corporate balance sheets globally is positive
for valuations and fundamentals. Moreover our US strategy team still expects
earnings growth to hold up this year, which would almost certainly help to
support valuations, and current earnings remain solid. For example, in the US,
we expect nearly all sectors to post positive growth in Q1.
How to position for a market rebound
Looking back over previous market sell-offs (-10% from 12-month peak) that
are followed by a sharp rebound (greater than 10% in three months) we find that
the sectors that led markets lower also tend to lead in the recovery (Chart 5).
This is an intuitive result insofar as a rebound in markets is probably driven by a
change in fundamental expectations that allows the most impaired sectors to
recover, while short-covering in bombed out sectors also reverses course.
As stated above, we believe that markets are poised for a broad recovery in
valuations driven by a decline in risk premiums. These moves are likely to
benefit the whole market. However, the historical pattern of a market rebound
suggests that the sectors that have been under the most pressure over the last
year (financials -22% and consumer discretionary -16%, compared to the market
which has been roughly flat) have potential to rebound sharply in the near-term.
Therefore, we have lifted our allocation to both of these sectors (financials to a
small overweight, consumer discretionary to a smaller underweight). Some of
the move in share prices will likely be a function of short-covering, while
additional gains will require signs of more sustainable growth potential.
In that vein, both sectors face hurdles that are unlikely to be cleared quickly. For
consumers, the US appears still at the early stages of recession, the
unemployment rate is likely to rise, and the downturn in housing will continue to
force household balance sheet repair. Meanwhile, financials will face continued
questions about growth potential in coming years given shrinking balance sheets.
These concerns are apt to cap valuations until growth and profitability
expectations become clearer. Thus, over a strategic horizon, both sectors may
struggle to outperform beyond an early-stage rally.
We are also making other changes to our recommended sector allocations. In
particular, we are cutting our position in defensive sectors – Healthcare and
consumer staples move from overweight to neutral – which we upgraded in
January. This reflects our more positive assessment of broader market
conditions and still-high relative valuations of these segments of the market. We
retain a preference for sectors that are exposed to business spending (e.g.,
Technology) relative to those with consumer exposure.
Our regional allocations remain unchanged. The US is our only overweight
region. We are neutral in Global Emerging Markets and in Japan. We are
underweight in Europe and the UK.
Banking bailouts: A history lesson
Our Global Banks Analyst Philip Finch published a report on March 17th called
“UBS Global I/O™: Banking Crisis – A banking bailout?” which takes a close
look at past banking crises and the parallels we can draw from them to help
understand the current turbulence. The team looked at four other crises with
similar features to today which were preceded by a long period of over-lending
and were all derived in one way or another from a real estate bubble. These bank
crises are 1) The Great Depression of 1929, 2) the Savings and Loans crisis in
1986, 3) the Swedish banking crisis in 1992 and 4) the Japanese banking crisis
of 1990. Stacked up against these prior episodes, the current subprime crisis
ranks second in terms of its cost as a percentage of GDP.
In these past instances, a fiscal policy response which was aimed right at the
underlying cause of these crises in hindsight marked a turning point in the
performance of the financials sector. Table 2 shows how on average the
financial sector returned 148% in the twelve months after the inception of the
government bailout. The team believe a swift response from the US government
this time could lead to a similar rally.
We recognize that a move to get less defensive still could be somewhat early
given the potential for concerns about the financial system and the economy to
linger. It will also be important to see how policy response evolves in coming
weeks to determine how much relief markets can anticipate. Overall economic
conditions may remain challenging as recession in the US appears probable. To
that end, sustainability of overall earnings growth may remain a concern as will
fears of a spreading global slowdown. These growth concerns could be most
acute in Europe and Emerging markets, where growth expectations have been
more stable. Moreover, materials and energy stocks could be vulnerable if
demand concerns finally trump expectations for limited supply, driving prices
A broad recovery. Monetary and fiscal policy response
to financial and housing market troubles has been
aggressive and more action is likely, though details of
further steps are still lacking. Combined with good
valuations and low interest rates, we believe conditions
are in place to see a decline in risk premiums that drives
valuations higher and results in a more sustainable rally.
Downgrade the defensive sectors. We cut positions in
Consumer Staples and Healthcare, as a broad market
rally makes holdings of defensive sectors, where
valuations are not cheap, less attractive.
Upgrade financials and consumer discretionary. We
upgrade these sectors based on historical experience
that the sectors which led sharp market sell-offs also
tend to perform best in the recovery. Longer term these
sectors still have structural problems to work through
before they are likely to sustain longer-term out
Overweight positive fundamentals. We take our
biggest overweight positions where we think
fundamentals are most positive longer term. Non
financial corporates have restrained capex this cycle
and have clean balance sheets. In general, therefore, we
prefer exposure to sectors with exposure to business
spending rather than consumer spending.
A preference for the US over Europe. European
equities have more headwinds to overcome including
slowing GDP growth, larger earnings downgrades,
strong Euro, and reluctance of the ECB to cut rates.
Neutral Japan. On many metrics Japan looks to offer
value. Investor sentiment remains cautious however
waiting for a catalyst for improved performance.
GEM outperformance less likely. As performance has
lagged in the developed world GEM now trades at a
premium to the world and could suffer a pullback if
economic concerns begin to shift East. Moreover, there
has been little downgrade of earnings in GEM.
Large Cap, Growth. We maintain a preference for
both large over small caps and growth over value.
Low Debt. Move up in credit quality and prefer strong
balance sheets given the pressures highly indebted
companies face in tough credit markets.
Risks to the view
Challenges remain Much of the stemming of systemic
risk in the financial markets was predicated on a fiscal
policy response from the US government. If this fails
to materialise or the Fed disappoints with future
monetary measures, substantial uncertainty could return
to the capital markets.