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Despite the strong gains over the last month for credit and major equity markets, Tom Elliott, Global Strategist at JPMorgan Asset Management, doesn't believe we've entered a sustainable rally.
The full economic impact of the credit crunch has yet to be felt in the G7 economies, as a rise in unemployment leads households to re-build their savings and to join the financial community in de-leveraging. This may lead to a downturn in consumer spending and bring still too-optimistic bottom-up profits forecasts down to the levels that are suggested by economic leading indicators.
Elliot adds that it could be that in a few years time we are near the top of another business cycle, with strong stock markets supported by profits growth. Hence, today's share prices could look like bargains in this scenario. However, current levels of volatility - though lower than earlier this year- suggest that enough uncertainty is out there to warrant a neutral position for global multi asset portfolios.
Bad news shocks from the financial sector are likely to have less of a negative impact as banks re-capitalise themselves and as liquidity is slowly restored to the financial system. Instead, the risk is of increasing bad news from the real economy as households and companies pay off debt and rebuild savings against a background of falling property prices (notably in Anglo Saxon and some southern European economies).
Against this background, notes Elliot, a rise in unemployment is likely, with major implications for consumer spending and corporate profits. It is through this mechanism that the overly optimistic bottom up corporate earnings estimates will come down to the more cautious levels suggested by the leading indicators.
"However, the downside is protected by attractive valuations relative to history and relative to bonds and credit. These measures suggest that equities are cheap even when using more conservative profits forecasts. In addition, institutions are sitting on large quantities of cash that are waiting to be invested," says Elliot.
01 May 2008 © Moneyextra.com
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