- Recent market weakness due to recessionary concerns
- We think growth could slow, but do not expect a full-blown recession
- To reassess our bullish view on US equities, we stress-test US earnings on the basis of zero percent economic growth in 2H 11
- Our stress-test indicates that even if growth stalls in the second half of 2011 and revenue growth is muted in both 2012 and 2013, S&P 500 earnings can still be at all-time highs by end 2012
- Even after revising down earnings estimates on slowing economic growth, we see fair value (at the end of 2012) for the S&P 500 at 1565 points, a hefty 30% above current levels
- Given that sentiment remains weak, there are near-term risks should earnings estimates be revised lower, but US equity market valuations remain compelling
- We maintain a 3.5 star “attractive” rating on the US equity market
Stocks Declining on Recessionary Fears
The recent plunge in US stocks has certainly rattled investors, with the US equity benchmark S&P 500 index declining 4.8% in a single trading session (on 4 August), the worst single-day decline since February 2009. While the recent weakness in the US equity market has been attributed to the impasse over the US debt ceiling, the continued decline in the US stock market (following a resolution in the US Senate) clearly suggests that other concerns are at hand, with recessionary fears remaining a primary worry at the moment.
Expecting a Slowdown, Not a Full-Blown Recession
While double-dip recession fears have surfaced recently, we are reluctant to join the “recessionary” camp. Current consensus estimates are for full-year growth of 2.5% (revised down from 3.1% earlier), and following the disappointing growth figures for 1Q 11 and 2Q 11, we will not be surprised if full-year growth comes in even slower than that. This still entails positive GDP growth over the next two quarters, which means a slowdown may be anticipated, but not a full-blown recession, which usually comes after a prolonged period of excesses.
Chart 1: Investment Still Languishing At A Low Base
Granted, consumption (which represents approximately 70% of US GDP) has been much weaker than expected in 2011, but our analysis of consumption expenditures indicates that high oil and gasoline prices were key factors depressing spending in 2Q 11. Energy prices have since declined substantially off their 2Q 11 highs, and we thus expect the energy burden on US consumers to be lowered significantly in 2H 11, which will provide a meaningful boost to US consumption. In addition, gross private domestic investment still remains a far cry from levels seen in 2006-2007, largely weighed down by residential investment. The investment component of GDP now makes up just 12.7% of GDP, compared to the 16.4% average from 2002-2007, and from this already-low base, gross private domestic investment will have to contract by an extremely large amount to drive overall GDP growth into negative territory.
While we continue to expect positive US GDP growth on a quarter-on-quarter basis, slower-than-expected economic growth may have some moderating effect on earnings going forward. To what extent will US stock market valuations be affected and will this impact our bullish view on US equities?
The Impact of Zero Percent Growth?
To reassess our positive stance on US equities in light of slowing economic growth, we attempt to forecast the impact of having the US economy grind to a halt over the next two quarters (3Q 11 and 4Q 11) and the corresponding impact on US corporate earnings, a situation which we consider a “worst-case” scenario at this juncture.
Stress-testing S&P 500 earnings
For this stress test, we assume that S&P 500 revenue growth grinds to a screeching halt alongside GDP growth in both 3Q 11 and 4Q 11, and that revenues then embark on a dismal 3% p.a. growth rate in 2012 and 2013, representing extremely conservative assumptions in line with our “worst-case” scenario approach. Under these stress-test assumptions, the US economy would grow by just 1.3% for 2011, and 2012 and 2013 GDP growth will be below 3%. Keeping with our conservative approach for this exercise, we assume profit margins will dip slightly from the current 9.1% to 8.7%, a reasonable assumption considering that corporate hiring has not picked up significantly (evidenced by the muted growth in nonfarm payrolls), which means overheads are not expected to increase going forward (see Chart 2).
Chart 2: Lowering Profit Margin Assumptions
Earnings to still be higher in 2012 and 2013
On these stress-test assumptions, we anticipate S&P 500 earnings will flatten off in the second half of 2011, before continuing to ascend going into 2012 and 2013 (see Chart 3). Earnings-per-share (EPS) for the S&P 500 under these assumptions are 87.3, 94.0 and 101.2 for 2011, 2012 and 2013 respectively. While these estimates clearly deviate from what the consensus currently expects, it must be remembered that these earnings were derived on extremely bearish conditions (zero percent economic growth over the next two consecutive quarters) and is certainly not our base case estimate. What these estimates serve to highlight is that even if growth stalls in the second half of 2011 and revenue growth is muted in both 2012 and 2013, S&P 500 earnings can still be at all-time highs by end 2012. Our base case estimate is lower than current consensus earnings, but still suggests healthy growth in US corporate profits to all-time highs in 2011, and places fair value (at the end of 2012) for the S&P 500 at 1565 points, a hefty 30% above current levels (as of 4 August 2011).
Chart 3: Stress-Test Earnings
Near-term risks if earnings revised lower, but valuations are compelling
Our assessment of equity markets has little to do with investor sentiment, and we remain keenly focused on the trend in US corporate earnings growth, which we view as a critical factor in the determination of stock market returns (see “How Does One Predict US Equity Market Returns?”). Recent profit announcements for US companies have been healthy, with over 70% of companies in the S&P 500 reporting stronger-than-expected earnings for 2Q 11 (as of 4 August 2011), which goes some way in explaining why consensus earnings have held steady despite ongoing concerns over the economy.
Even with strength in corporate earnings, recent market volatility has been to the downside, and there are certainly some near-term risks for US equities should the consensus begin cutting earnings estimates on slower growth expectations. Nevertheless, even on our stress-test estimates, earnings will still continue to grow (albeit at a slower pace) even if economic growth stalls in the second half of 2011. On all three measures (consensus, base case and stress-test), the US equity market remains at a meaningful discount to our estimate of fair PE (see Chart 4), representing compelling valuations. We anticipate that investors who have a longer-term investment horizon to ride through the anticipated volatility may find interesting opportunities over the next few weeks, and in view of the strong potential upside (even if earnings estimates are cut), we maintain a 3.5 star “attractive” rating on the US equity market.
Chart 4: Discount to fair value