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Earnings recession looms

Created:
16 June 2008
Written by:
Simon Thompson

For the past two months, I have been studying UK bear markets and their key characteristics over the past 100 years - with some informative findings.

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First of all, research from investment bank Morgan Stanley shows that the bumper return on equity (ROE) enjoyed by corporations across the eurozone at the peak of the bull market last year is simply unsustainable. In fact, in every single bear market in the past 34 years, top-of-the-cycle ROE has eventually reverted back to the mean. It is therefore worth remembering that ROE for the European MSCI index peaked at 18 per cent last year. That figure is not just at a 34-year high, but is significantly ahead of the 10-year average ROE of 14 per cent and the 34-year average of 10 per cent.

It's not too difficult to find catalysts for a major earnings recession in the UK and the eurozone. Take your pick: we have a bursting of the real-estate bubble, the ongoing fall-out from the credit crunch, oil crisis and potentially worst of all, an inflation/stagflation problem. We also have to face up to the stark reality that consumers and banks have stretched their capital bases to the limit, and are now in the painful process of deleveraging and rebuilding their balance sheets. At least the banks have been able to tap shareholders and bondholders to put themselves on a firmer footing.

Unfortunately, over-extended consumers are in a far more precarious position, weighed down by high levels of borrowings just as the value of their collateral - mainly property, but also other asset classes including equities - is falling. To put this consumer credit bubble into perspective, in the last decade, household debt in the UK has risen from 70 per cent of disposable income to an eye-watering 175 per cent.

The inflation problem

Worryingly, with the disconnect between the Bank of England (BoE) base rate and Libor wholesale money market rates as wide as ever, and the yield curve steepening to reflect higher inflation expectations, borrowing costs are now getting more, not less, expensive. This is very bad news for over a million mortgagees coming off fixed-rate mortgages this year. These had been priced at very low rates during the credit bubble years, so the impending hike in rates will hit hard. It's also bad news for profit margins of companies, as those inflated money market rates feed through to higher borrowing costs.

No help from officialdom

And don't expect any respite in the near term, because until the BoE Monetary Policy Committee (MPC) gets the inflation genie back in the bottle, rates are set to stay stubbornly high. Indeed, input producer price inflation (PPI) is running at a 28-year high, and consumer price inflation (CPI) above the 2 per cent inflation target and testing the 3 per cent level. This is the point at which Mervyn King, the Governor of the Bank is obliged to send a letter explaining the overshoot to the Chancellor - so it is easy to see why the MPC held UK base rate at 5 per cent earlier this month. We can count ourselves lucky though, as eurozone borrowers face an even harsher situation, with the European Central Bank considering interest rate hikes to combat inflation.

Inflationary pressures are having a direct impact on our net disposable incomes as escalating mortgage payments, along with higher energy, commodity and food bills take a larger share out of our take-home pay. These pricing pressures are also about to take a chunk out of company’s margins and profits, too, as businesses find it increasingly difficult to pass on the full input cost increases to end users given the ever widening gap between the PPI and CPI. Remember that businesses are battling against a deteriorating trading environment as greater numbers of consumers have no choice but to rein back discretionary spend.

Nor are governments about to lend a hand. In the UK, state coffers are bare, with both the current account and budget deficit near record levels. So with the economy slowing rapidly - even Mr King has highlighted the risk of recession and stagflation - the public finances are likely to get worse as corporation tax receipts come under pressure.

Earnings forecasts are set to fall

Another interesting historical fact about bear markets is that they generally don't end until earnings have troughed out. That's worth noting, because although the UK stock market looks inexpensive trading on 11 times earnings, this rating is illusionary as the risk to earnings estimates is down, not up. This is why the FTSE 250 is being derated most, as it has the largest weighting to cyclical consumer facing sectors that face the greatest earnings downgrades. The situation in the eurozone looks just as bleak, though, with Morgan Stanley expecting a 21 per cent peak-to-trough correction in earnings.

In the circumstances it would be logical for equity markets to endure a pretty rough ride over the coming months as the stark reality of the situation sinks in. I would therefore recommend keeping open all the short index trades that I have advised this year. These are a FTSE 250 short-listed contracts for difference (CFD), C433 (Bad Tidings, 11 January 2008 - showing a profit of 21 per cent), Global Bear Market Accelerator Note, SN01 (Bear Necessities, 14 January 2008 - profit of 9 per cent) and FTSE 100 covered put warrant, SM29 (Get Shorting, 2 May 2008 - profit of 19 per cent). I would also use any countertrend rally as an opportunity to add to these shorts.

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