Four key observations/ Investment implications
(1) Emerging market credit spreads have held up very well relative to corporate
credit spreads. In part this is because the market has not sold off aggressively the
‘growth’-sensitive regions (GEM, Japan) and cyclicals, but to a larger extent it reflects
that emerging markets are now much ‘safer’ as a group. This is because both NJA and
LatAm have near-record current account surpluses and record foreign exchange
reserve accumulation. Investment conclusions: (a) Stay overweight more resilient
GEM (i.e. LatAm, NJA—albeit we reduced our overweight on 30 July). After all, NJA
has a 0.7% higher equity risk premium than the US with much less macro risk. We are
now also overweight Hong Kong: (b) Still focus on the indirect plays on emerging
markets: mining/metals, consumer staples with high GEM exposure (Inbev, Nestle,
SAB Miller), luxury goods (Swatch, Richemont), banks with high GEM exposure (SAN,
KBC), technology (GEM account for 60% of handset demand, 47% of PC demand).
We are only cautious about those GEM that need global liquidity to fund large basic
balance of payment shortfalls (South Africa, Hungary).
(2) For the first time in eight years, equity sector risk appetite is much higher
than overall risk appetite and is still above average. The equity market,
especially in Europe, has not sold off the ‘growth’ plays aggressively. The
correlation coefficient between cyclicals and risk appetite is 0.73. Investment
conclusion: this is partly why we downgraded European cyclicals on 13th August.
The only cheap cyclical sectors where we remain overweight are metals/mining
and technology. We prefer US to European capital goods given less stretched
valuations, the dollar and less end-market sensitivity to liquidity conditions. Herein,
we screen for expensive cyclicals in continental Europe.
(3) When the LIBOR/Treasury spread has previously been this high, banks
were much more cheaply rated. The banks we currently prefer are those where
the customer is under-leveraged, the value of collateral is relatively ‘safe’ (with
property yields above bond yields) and loan/deposit ratios are below 95% (with
decent capital ratios adjusting for conduits). Country-wise, this highlights Greece,
Belgium, France, Italy, Japan and parts of NJA. We would highlight NBG, KBC,
Intesa, Postbank, BNP, Credit Agricole, Sumitomo Mitsui.
(4) The catch 22: The US forward curve is discounting 65bp off rates by year-end
(25bp cut in September) but consensus GDP growth numbers are still high at 2.6%
for 2H 2007 and 2.8% for 2008. Only in recession and the LTCM crisis have rates
been cut this quickly. We believe that consensus US GDP growth numbers are
vulnerable—we estimate that directly and indirectly from here housing weakness
takes up to 1.5% off GDP. The concern is bad economic news will probably come
before the good news on Fed rates. During the LTCM crisis the equity market
troughed on the second Fed rate cut. Investment conclusion: buy volatility (SwFr,
VIX) for September. We are bullish on equities for Q4 not necessarily very shortterm
(we reversed our 19th July downgrade of equities on 20th August). We find
European cyclicals with US exposure still quite highly rated (page 22) and believe
it is too early to buy US consumer cyclicals.
