3Q 2011 was an extremely eventful and nerve-wrecking quarter.
In the US, the downgrade of the US sovereign rating by Standard & Poor's by a single notch at the beginning of August saw the world’s largest debtor lose its AAA-rating, spooking markets and heightening risk aversion. The political bickering and eleventh-hour passage of the raise of the deficit ceiling had contributed its fair share to market volatility prior to the downgrade although the end result was never in doubt. Economic data coming out of the US in 3Q was not encouraging. Along with stalling jobs growth, 1Q GDP growth was revised downwards and 2Q GDP growth stagnated as the economic recovery began to run out of steam.
During the specially extended 2-day FOMC meeting in September, Ben Bernanke, chairman of the Federal Reserve, announced what markets termed “Operation Twist”. In summary, the Fed was seeking to purchase USD 400 billion of longer-dated treasuries by selling its existing holdings of shorter-term maturities. The Fed’s plan is expected to bring down longer-term rates, cutting the cost of mortgages and business loans with the intention of spurring consumption and investment by households and the private sector respectively. Despite the fact that “Operation Twist” was telegraphed by the market and can be deemed as “accommodative” monetary policy, the lack of a “QE 3” which markets were hopeful of saw the US equity market react negatively.
Across the Atlantic, the re-ignition of Greek debt concerns saw the sovereign debt crisis spread to Italy and Spain as markets questioned the credibility of the countries involved, raising the yields on their bonds to all time highs during the Euro era. The ECB was forced to come to the rescue of both the Italian and Spanish bond markets as they restarted the buying of new debt issuances by both countries in an attempt to keep the yields down and restore calm to the market. Italy, which possesses the world’s 3rd largest bond market, was forced to bring forward plans by 1 year to balance their budget and reduce their budget deficit. Both Italy and Spain have introduced austerity measures which will see a cut in public spending and the implementation of new taxes. These austerity measures are expected to have a negative impact on GDP growth once fully implemented. With 2Q GDP growth almost non-existent for the Eurozone at large, the latest wave of austerity measures could see negative GDP growth in 3Q 11 as government spending falls in the face of budget cuts, corporate investments and household consumption ease in the face of growing uncertainty as to the resolution of the debt crisis.
Although President Sarkozy and Chancellor Merkel explicitly ruled out Greece leaving the single currency, talk of a potential Greek default by the markets gained momentum when European officials refused to rule out an “orderly default” of Greek debt. The news saw credit default swaps (CDS) on Greece’s sovereign debt jump to all-time highs, effectively pricing in a certain default over the next five years. At the time of writing, the Troika has yet to return to Greece and approve the next tranche (EUR 8 billion) worth of payouts to the Greek government as they attempt to ascertain the progress made by the Mediterranean nation. The EU has yet to ratify the expansion of the European Financial Stability Facility (EFSF) with several nations yet to vote on the enhanced powers of the fund (which was proposed on 21 July 2011). Meanwhile, European leaders are engaged in discussions on how to potentially leverage the fund to provide “maximum” firepower in a bid to quell the latest crisis, as markets continue to be volatile.
Despite many of the problems originating from the developed economies in the West, equity markets worldwide, particularly the global emerging markets led by the BRICs have encountered heavy selling as investors sought refuge from riskier assets and shifted much of their portfolio into safer assets such as US treasuries which have seen its yields pushed down to historic lows.
With that having been said, let us take a closer look at some of the key factors that have provided the support or pressure that has attributed to the performances of the top three (Technology, Indonesia and the US) and bottom four (Brazil, Russia, India and China) performing markets.
|Table 1: Market Performance (in SGD terms)
||MSCI AC WORLD IT
||S&P / ASX 200
||Bloomberg AP Tech
|Asia ex japan
||MSCI Asia Ex-Japan
||MSCI Emerging Markets
|Source: iFAST Compilations
Data as of End September 2011
Top performing markets
The Nasdaq 100, our proxy for the Tech sector, declined 2.1% year-to-date (in SGD terms, as of end September 2011) but fared the best amongst equity markets under our coverage. Relative strength in the index was provided by companies like Apple (+18.2% YTD), Baidu (+10.8%), Amazon (+20.1% YTD) and Ebay (+6% YTD), while heavyweights Microsoft (-10.9%), Google (-13.4%) and Cisco (-23.4%) weighed on the overall index.
The US semiconductor equipment manufacturer book-to-bill ratio, an indicator of future Tech demand, has been below parity for eleven consecutive months, a function of declining new bookings. Dampened interest for new machinery is not surprising, considering the volatility experienced in financial markets this year, bringing with it the uncertainty over future demand. Nevertheless, global semiconductor sales has held up relatively well, remaining at around the USD 25 billion mark in August 2011 (albeit 0.3% lower year-on-year), and indicate that end-user demand has not dropped off as substantially as stock markets have suggested. In addition, we observe relatively modest levels of inventory build-up in computers and electronic products, a far cry from the excesses seen prior to the 2000 downturn in the sector, which suggests that Tech companies are better-positioned to deal with any impending slowdown in demand.
While IT spending may slow in the near-term as the corporate sector deals with immense uncertainty in the global economy, we expect corporate IT spending to rebound sharply as growth concerns eventually wane, and our forecasts are for Tech companies to post a muted 2.5% increase in earnings this year, before posting 18% and 20% earnings growth in 2012 and 2013 respectively. These estimates translate to Tech stock valuations of 15.9X, 13.5X and 11.2X for 2011, 2012 and 2013 respectively (as of 30 September 2011), a hefty discount to our fair value assessment of 16X PE for the sector. We have a 4.5 star “Very Attractive” rating on the Tech sector.
The Indonesian market was unable to avoid suffering from the recent selloff pressure emanating from the economic slowdown in developed markets and the heightened contagion risks in Eurozone. However, the impact on the Jakarta Composite Index (JCI) was less severe compared to other emerging markets with the index recording an 8.7% loss in Q3 2011 and a year-to-date loss of 4.4%, in SGD terms.
The reason for JCI emerging in the top performing markets list is mainly due to its exceptional performance in the first seven months in 2011. With that being said, the gains were completely erased in the month of September when a massive selloff triggered by foreign investors marked the largest drop in a single trading day of 8.9% or 328.4 points on 22 September 2011. The above is evidenced by the outflow of foreign funds with USD 91.5 million leaving the market on that day alone. The Indonesian Rupiah caved into pressure to depreciate against the USD, declining by 5.8% in September as compared to 0.9% on a year-to-date basis. With the rise of global uncertainties and negative investor sentiments, foreign investors reduced their exposure to perceived risky emerging market assets in a flight to safety.
The recent tumble of the JCI is in stark contrast with Indonesia’s economic performance. Indonesia’s economy is expected to continue its strong growth which is forecasted to register a rate of 6.5% and 6.6% in 2011 and 2012 respectively. The country’s economic growth has been underpinned by robust domestic consumption and demand for natural resources from India and China. With inflationary pressures easing from 5.9% in 2Q to 4.7% in 3Q of 2011, the central bank of Indonesia paused the interest rate hike cycle, since January’s 25 basis points hike which brought the rate to 6.75%, in order to support economic growth. Indonesian corporate earnings are expected to grow by 15.3% and 17.5% in 2011 and 2012 respectively.
The JCI traded at a PE of 14.9X and 12.7X in 2011 and 2012 respectively based on in-house earnings estimates. Although trading at a slight discount to its fair level PE of 15, we believe the market’s upside potential has been substantially realised, as such, we maintain our 2.5 stars “Neutral” rating on Indonesia.
In USD terms, the S&P 500 delivered a -10% return over the first three quarters of 2011, with a sharp 14.3% decline coming in 3Q 11 alone. Investors fled to USD-denominated assets as risk aversion increased, resulting in a strong rebound for the dollar index in September. The appreciation of the USD against most Asian currencies in the third quarter mitigated US stock declines due to currency translation effects, with the S&P 500 lower by 9.2% in SGD terms for 3Q 11.
The fragility of the US economy has been a major concern throughout 2011, with weaker-than-expected 1Q and 2Q growth figures forcing the consensus to lower their estimates of US GDP growth throughout the year. In fact, some forecasters are now suggesting that the US economy is moving back into recession. This is not our base case forecast, and despite our expectations that the Euro-zone will slip into a mild recession, we forecast that the US economy will continue to grow, albeit at a slow pace.
Consumption has been much weaker-than-expected in 1H 11, which we attribute to the high energy costs which have weighed on discretionary spending. US gasoline prices rose 29% over the first four months of 2011, but have since declined 13.2% from their peak in early May, which should help to alleviate some of the energy burden on the US consumer. The stronger USD should also aid in reducing food and energy import costs. With home prices having fallen over 30% from their peak levels and housing activity at a fraction of 2006 levels, many are clearly concerned about the sorry state of the US residential housing market. While these are worrying indicators, we note that residential investment as a percentage of US GDP has declined from 6% in 2004 to an all-time low in 1Q 11, and any further deterioration in the sector should have little direct impact on overall US GDP.
While GDP growth has been weaker-than-anticipated, corporate earnings have not reflected this, and profits of US companies have generally exceeded expectations in both 1Q 11 and 2Q 11. To take into account our more conservative expectations of US economic growth, we have revised down earnings estimates for S&P 500 companies, and now expect earnings growth of 1.3% and 7.5% for 2011 and 2012 respectively, before posting a stronger-than-trend recovery for 19.8% profit growth in 2013. On our estimates, US equities are trading at 13.1X, 12.2X and 10.2X earnings for the three respective years, representing extremely attractive valuations as at 30 September 2011. We have a 4.0 star “Very Attractive” rating on the US equity market.
Bottom performing markets - SINKING LIKE A BRIC
The Global Emerging Markets geographic category suffered the most at the hands of investors who dumped perceived riskier assets in a flight to safety. Amongst the worst performing markets were the famous BRICs (Brazil, Russia, India and China), who despite powering on with strong economic growth, saw their equity indices correct by over 20% individually, sending them into bear market territory. With such dismal losses in the equity market, an examination is due for the BRIC countries.
The Brazilian equity market, represented by the Bovespa index fell -25.4% in SGD terms in 3Q 2011 on a quarter-on-quarter basis. On a year-to-date basis, the index has fallen by -31.8% in SGD terms to end up as the bottom performer in the markets under our coverage.
Latin America's largest economy has seen its economic activity decelerate amidst a challenging external environment. With capacity utilisation slipping to the 82% mark, the lowest reading since February 2010, the latest economic activity index readings show a slowing expansion as growth has slowed from 2.93% previously to 1.66% in July on a year-on-year basis. Looking forward, we expect further cooling in the economy as global growth slows and the various fiscal and monetary policies implemented earlier in the year begin to take effect.
Inflation in Brazil last measured a 7.23% year-on-year growth rate in August 2011, significantly above the government's target of 4.5% (plus/minus 2%). In response to inflation's growing threat, the central bank had hiked interest rates 5 times, or, by 1.55% since the start of the year, raising the Selic benchmark interest rate to 12.50% in the middle of July. However, the central bank has backtracked and cut interest rates by 50 basis points citing “substantial deterioration” in the global economy at its end of August meeting, signalling its prioritisation of economic growth over price control.
With inflation being driven by Demand-Pull factors such as strong domestic consumption which saw retail sales rise by 7.10% in both June and July on a year-on-year basis (spurred by low unemployment and rising real wages), it remains to be seen if the government can curb amongst other things, credit growth which was last measured at a 19.40% year-on-year rate in August, and has seen default rates rise to 6.70% in the same month, beginning to spark fears that a credit bubble might be brewing.
Being heavily weighted in the energy, industrial and material sectors, the Bovespa index has suffered as commodity and raw material prices fell in Q3 2011, ending the quarter with a YTD return of -31.8% in SGD terms. Our conservative estimates of corporate earnings growth forecast 2012 and 2013 earnings growth of 17.1% and 15.8%, the Bovespa trades at PE ratios of 8.3X and 7.2X (as of 30 September 2011) for 2012 and 2013 respectively, representing a discount of 59.7% from our fair value estimate of 11.5X earnings based on 2013’s estimated earnings levels. We maintain a 4.5 star “Very Attractive” rating on the Brazilian equity market.
Shifting our focus from the Latin American nation to Russia, the Russian equity market surrendered all of its gains made in 1H 2011, epitomising the haemorrhage that global equity markets experienced in 3Q 2011.
The Russian economy has seen its economic outlook dim with the Manufacturing Purchasing Managers index (PMI) continually shrinking from 55.6 points in March to 49.9 in August, a sign that the nation’s manufacturing sector is contracting. Despite consumer demand’s continuing recovery towards August 2008 levels as disposable income rises, the inflationary threat has continued to ease with the headline Consumer price index (CPI) slowing to 8.20% year-on-year in August, down from a 9.00% reading a month earlier. On a year to date basis, consumer prices were just 4.7% higher as of end August, compared to 8.7% for the whole of 2010.
As far as oil prices are concerned, we remain cautious with regards to oil prices as rising global growth risks and the sovereign debt woes in Europe threaten to dampen demand. With lower prices of Ural crude and thus value of exports, Russia’s national budget might be under pressure and would make its budget deficit reduction plan harder to implement. The former super-power’s over-reliance on exports of commodities, particularly oil & gas, leaves the Russian economy dependent on external demand to foster economic growth. However, given the resurgence of consumer spending and political stability, the outlook for Russia is encouraging.
At its current level as of 30 September, Russia’s RTSI$ index has lost -23.5% in SGD terms on a YTD basis, losing -25.4% in Q3 11 alone as commodity prices have tumbled and investors pulled money out of the country’s stock market. Based on our conservative estimates which forecasts earnings growth of 5.7% in both 2012 and 2013, Russia is currently priced at 4.5X and 4.3X PE, with potential upside of 74% by 2013. We maintain a 4 star “Very Attractive” rating on the Russian equity market.
Moving to the Asian continent, India has been amongst the worst performing markets since the beginning of the year. In the quarter of June-September 2011, the Central Bank has increased the major policy rate twice, once by 50 basis points in the First Quarter Review held on July 26 and by 25 basis points on Sept 16 in the Mid-Quarter Review. Thus the Repo rate increased to 8.25% and Reverse Repo rate got automatically adjusted to 7.25% and the marginal standing facility rate to 9.25%. Despite hiking rates 12 times since March 2010, inflation continues to remain a concern for policy makers as the Wholesale Price Index which was at 10.36% in March 2010 has only managed to be reduced to 9.78% as at August 2011. The Central Bank’s statement that it will continue to be hawkish in its monetary stance till inflation comes into its comfortable range has negatively impacted market sentiments.
Weak quarterly corporate results, which came in below expectations, as well as earnings downgrades continues to be a cause of concern for investors as they fret over the profitability of companies in India. Other negatives on the macro front include the 1Q GDP growth rate of 7.7% as compared to 8.8% in the same period last year, inflation stubbornly remaining above 9% and volatile industrial production weighed on the market sentiments. Like global equity markets, the Indian market was not spared from the wrath of global uncertainties.
The estimated P/E for SENSEX as on September 30,2011 stands at 14.2 for fiscal 2011 (Ending March 2012) and 12.2X for fiscal 2012 (Ending March 2013) based on estimated earnings growth of 9.5% and 16.0% for these two financial years. Despite the poor performance of the Indian market as it lost -25.7% in SGD terms on a year to date basis, we continue to believe that Indian markets are trading at attractive valuations although the market will likely remain volatile from both domestic and global factors. At its current levels (30 September 2011), the Indian market represents potential upside of 40% by March 2013.
We maintain a 4 star “Very Attractive” rating on the Indian equity market.
Across the Asian continent, the Hang Seng Mainland 100 Index dropped by 24.3% year-to-date (in SGD terms) with both the year-to-date and 3Q returns ranked third from bottom for the markets under our coverage. The monetary tightening policy adopted by the Chinese government started to see its impact in the announced 3Q economic data. For example, the Purchasing Manager Index dropped to a range of 50 to 51 during June to August. The slower growth in manufacturing has increased the worry of a potential hard-landing in China.
In addition to the recent risk aversion due to the European debt crisis and worries of slower growth in the US, there are market whispers that many corporates and business owners in China are unable to repay their high rate loan. The whispers have drawn market attention to the health of the Chinese banks’ loan book and the quality of the loans. Due to the worry about the potential increase in banks’ non-performing loans (NPL), the Chinese banking sector (listed on the HK stock exchange), as represented by the Hang Seng H-Financials index dropped -34.96% year-to-date (in SGD terms). As 34% of the HSML100 index is composed by the H-financials sector, the huge drop in the financials has been one of the key drivers of the market’s poor performance.
However, with an increase in net interest margins, a provision-to-bad debt ratio which is higher than 2 (as of Q4 2010) and a Return of Equity above 20%, we believe that the market has over-reacted to marker whispers and the sector is positioned to weather potential further increases of NPLs. The estimated price to book (PB) for the Hang Seng H-Financials index is trading at 1.17X. In terms of the estimated PB, it is now trading at a lower level than during the Lehman crisis 3 years ago.
Given our estimated earnings growth of 8.7% and 17.9% for 2012 and 2013 respectively, China is currently priced at 7.7X and 6.5X earnings for the two respective years. With potential upside in excess of 100%, we continue to favour this economic juggernaut as even if a soft landing materialises, there is plenty of room for policy manoeuvres the government could take to avert a damaging hard landing. We continue to maintain China’s star rating at 5 “Very Attractive”, the highest rating among the BRIC sector with a 3 year horizon.
In 3Q 2011, equity markets around the world were sold off as panic and volatility gripped the capital markets as indiscrete selling across markets and assets saw investors get pounded over the past 3 months with several markets losing their positive returns gained in 1H 2011.
As we move ahead into 4Q 2011, we believe the sell-off in equity markets in some regions and single countries are unjustified. The underlying fundamentals of our 12 upgraded markets are supportive and well poised to provide attractive equity market performance with strong upside potential even on the back of forecasting a mild recession in Europe. Thus, we retain our conviction in favouring equities over bonds and refocus our overweight in equities in the Global Emerging Markets and Asia Ex Japan space, with a focus on value and not price.