Declining confidence plus a fragile recovery equals a potentially dangerous combination for equities

Shaun le Roux of Alphen Asset Management discusses a declining confidence in Equities.

In dollar terms, the FTSE/JSE All Share has shed no less than 18% since early April.

Over the past two months market sentiment has deteriorated sharply. Before the recent correction, we argued that markets were surprisingly complacent and focused on short-term profit growth, with limited attention being given to medium-term risks and rich valuations. The Greek debt situation has triggered a full-blown crisis in the Euro-zone, and markets have moved sharply from complacency to panic.

The problem with the Euro-zone crisis is that there is no quick fix. Within the euro, a single currency with a single central bank are housed some very different economies, some of whom have perilous fiscal balances and significant sovereign debt exposures. In other economic zones a co-ordinated effort to stave off the crisis - usually involving the printing of a massive amount of money – would be more effective because there is only one currency and one country involved. The euro has no efficient mechanism for dealing with peripheral (or central) economies that cannot service or roll-over their debt. This crisis has a distance to run, though it could be argued that the decline in the euro has gone some way towards pricing in and alleviating the long-term economic shocks.

Unfortunately, the onset of the euro crisis coincided with pretty rich valuations on equity markets generally and a rosy consensus on the outlook for sustained global economic recovery. No-one can argue with the fact that the past year has seen a sharp recovery in economic growth. However, some financial indicators, such as a rolling over of leading economic indicators, further declines in US house prices and very weak jobs data, are starting to suggest that perhaps the global economic recovery is in the process of stalling. This is not good news.

A significant proportion of the snap-back in economic activity can be attributed to the extraordinary level of government stimulus and, going forward, growth will have to do without artificial intervention. Also, by now one would have wanted to see a marked improvement in the jobs market (refer to the chart below). This is why Friday’s very weak US payroll numbers rattled the markets. It is clear that US employers are still reluctant to hire new workers. Until we can say with confidence that jobs are starting to be created, the economic recovery will be fragile.

It is also worth keeping a very close eye on the US housing market. Remember, this was where the 2008 global financial crisis had its origins. Unfortunately, recent data has indicated that, whilst government intervention may have stabilized house prices last year, they are starting to decline again, and the recent sharp declines in mortgage applications and continued high levels of housing inventory don’t bode well for this key market. The fortunes of the US consumer closely follow those of their largest asset, their home.

The combination of poor and declining investor confidence and a potential stalling of the economic recovery could be a very dangerous combination for equity markets. We perceive few stocks on the JSE to be cheap and continue to advocate that investors exercise caution.

We would be particularly cautious of expensive domestic equities which have benefitted from significant foreign inflows in recent months and have emerged relatively unscathed from the recent correction. It is apparent that the foreigners perceive South Africa as somewhat of a safe haven at the moment, given our relatively sound fiscal position and higher level of interest rates. The rand, and SA domestic equities, remains vulnerable to deteriorating global appetite for risk and, like consumers right around the world, South Africans are still trying to reduce their level of indebtedness. We do not anticipate significant demand for credit in the months ahead. It is our view that many domestic shares are pricing in very healthy profit growth over the next few years and returns are likely to be mediocre at best.

In this environment, careful stock picking with a particular focus on risk will serve domestic investors well.

The Alphen Angle is an electronic publication of PSG Alphen Asset Management