Key Points:

• Equity markets have experienced sharp declines over the past month, and the substantial losses requires us to reassess our ratings for the various equity markets under our coverage
• Having made changes to our outlook on Euro-zone and US economic growth, we have revised earnings estimates downwards for markets under our coverage
• Muted PE ratios and high levels of excess earnings yield suggest that the stock market is attractively valued
• Recent stock market declines suggest a large permanent impairment to the earnings potential of the stock market in aggregate, but we do not think this is the case and expect any earnings impairment to be temporary
• On the back of stronger potential upside forecasted for markets under our coverage, we are upgrading our star ratings for 12 equity markets
• Given our recessionary forecasts for the Euro-zone and the implications on earnings, we are downgrading our rating on Europe

Sharp Declines For Various Markets

August has been a difficult month for equities, with markets under our coverage declining between 5.1% and 18.8% (see Table 1) on a month-to-date basis as of 26 August 2011. In light of the sharp declines for most equity markets, we are reassessing ratings on the various equity markets under our coverage.

Adjusting Earnings For Lower Growth

Over the long term, the growth in earnings dictates the returns of the equity market, which is why we place much importance on earnings as an input to our stock market forecasts. Previously, we have been happy to utilise consensus earnings forecasts as a basis for our own estimates, but our economic outlook now differs from the consensus view, requiring some changes to our forecasts. We now expect a mild recession in the Euro-zone and lower-than-expected growth in the US, which has negative implications for corporate earnings, and we have correspondingly lowered earnings estimates for equity markets under our coverage, attempting to factor in lower anticipated economic growth. Corporate earnings will likely see some negative impact in 2012 as growth stalls in the Euro-zone, but we expect the slowdown to be short-lived and thus forecast a stronger recovery in earnings for 2013 (the stronger percentage increase relative to consensus estimates reflects the low base of our 2012 estimates).

Valuations Remain Compelling, Especially When Compared Against Bonds

Even with our lowered earnings estimates, valuations for most equity markets under our coverage remain compelling, and several have a single-digit PE ratio based on forecasted 2013 earnings (see Table 3). When one takes into account the paltry yields available on most sovereign debt, the discount on equities is even starker. We calculate excess yields by comparing the inverse of the PE ratio with the yield available on 5-year sovereign bonds to gauge the relative attractiveness of equities vis-à-vis bonds. High excess yields indicate that equities are relatively more attractive while low or even negative excess yields suggest bonds are more attractively valued. At this juncture, excess yields (see Table 4) are strongly positive for almost all equity markets under our coverage, highlighting the relative attractiveness of the equity market and vindicating our “overweight” call on the equity market vis-à-vis bonds. 

Stronger Potential Upside Forecasted For Equity Markets

The substantial declines in many equity markets in August appear to suggest a significant (and permanent) impairment to the earnings potential of the stock market in aggregate. On the other hand, our estimates (which are based on fairly conservative assumptions of global economic growth) suggest that such impairments to earnings will be a temporary affair, and we fully expect corporate earnings to resume their upward trend as global growth ultimately gains traction.   

In our opinion, the sharp falls in equity markets have actually increased our expectations of potential upside for various markets under our coverage, following the substantial decline in market valuations since the beginning of the year (a result of stock prices declining by a much larger extent compared to our estimate of earnings impairments). As of 26 August 2011, our estimates indicate that 9 of the 18 markets under our coverage have the potential to deliver a greater-than-20% annualised return by the end of 2013 (see Table 5).

Upgrading 12 markets, downgrading just one

Having satisfied ourselves with a more muted outlook on global growth and having made downward adjustments to earnings forecasts, stock markets still sport very attractive valuations (based on our revised estimates which are more conservative compared to the consensus). On the basis of the strong upside we expect, we are upgrading 12 markets under our coverage (see Table 6). Among the list of markets, some of the largest upgrades come from India (2.5 to 4 stars) and Brazil (3.5 to 4.5 stars), which have been two of the worst-performing equity markets year-to-date.

The only market we have downgraded is Europe (4 to 3 stars), on the basis that earnings growth will be hampered by an economic slowdown and will likely be sluggish, even going into 2013. Our projected upside for European equities is thus not as substantial as the other regional equity markets and we have downgraded the market’s rating as a result. Following the changes, Asia ex-Japan and Emerging Markets are our top-rated 5 star regional equity markets, while the North Asian equity markets (South Korea, China, Hong Kong and Taiwan) are the highest-rated single-country markets under our coverage (5 stars). Following our latest changes, all markets under our coverage are rated at 3 stars “attractive” or higher, highlighting the value we see in a depressed equity market.  

Looking Past The Current Turmoil

Most equity markets have experienced a strong correction, but we doubt that the steep downward movement in prices is justified given that valuations were already modest prior to the recent period of decline and that a deep recession mirroring the recent 2007-2009 experience is not on the cards. Under such tumultuous market conditions, investors should remember to make the distinction between price and value (see “Value, Prices & Volatility”), with price being what one pays (or receives) in the marketplace at any given time, and value being the underlying worth of the companies which make up the stock market. Prices tend to be suppressed when expectations and sentiment are weak, and we expect that investors who can see past the current turmoil will be able to reap substantial rewards when prices become more reflective of the value of the underlying companies in the future.