Research Analyst at Goldman Sachs, have described the profile of the equity market this year as ‘fat & flat’ – a wide trading range but with relatively low aggregate returns.
Key Quotes
“The market has staged a partial rebound from the sharp falls at the start of the year. We see much of this as about positioning rather than fundamentals. To get a sustained recovery, we think that either the market falls further and becomes truly cheap or it is likely to remain volatile and directionless in the near term until we see a turn in economic fundamentals, the oil price and inflation expectations.
The third wave: There were many causes of the correction at the start of the year, but we think that much relates to the ‘Third Wave’, or EM phase, of the financial crisis (the first wave being the US sub-prime crisis and the second wave the European sovereign crisis). Given that the previous waves have required aggressive policy intervention, currency devaluation and QE, there have been understandable concerns about the deflationary consequences of similar adjustments in EM at a time when investors doubt the scope and impact of further monetary easing.
The rebound in a fat & flat market: We have seen a strong equity bounce in recent weeks, but we think much of this reflects positioning and short covering rather than greater confidence in fundamentals. We also think the rally initially had more to do with a pushing out of US rate rise expectations and a weaker dollar (taking pressure off EM assets and the dollar) than a rise in growth expectations. True, most recently some of the US data has improved and importantly the CNY has stabilized, but inflation expectations remain very depressed. Herein lies the opportunity. However, while equity valuations have fallen relative to bonds (we estimate the ERP in Europe is back to the highs of the financial crisis) absolute valuations remain relatively high by historical comparison.
Triggers for a rebound: For equities to move meaningfully higher from here, we think valuations would need to be cheaper first (around 11x or 12x forward earnings compared with 14x currently). Without this, the market is likely to remain volatile, but tread water until there is a clear shift in inflation expectations. When either (or both) of these things happen, we expect a sharp rally led by financials (where valuations are overshooting), with staples most at risk.”
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