God Bless You

By Rudi Filapek-Vandyck

Seven hundred years ago in Europe, whenever someone would sneeze people would instantly respond with “May God bless you”. The social tradition has since spread around the world and remains in practice to today.

In modern times the practice has become a gesture of politeness, but back then, in the fourteenth century, things were different. If someone sneezed this could mean the person had caught a cold, which weakens the body and can cause severe discomfort. There was no social security in place, so any illness indicated bad news.

Sneezing could also mean the person was on route to develop a more severe illness, such as the flu or bronchitis. Under a worst case scenario, sneezing could be the first signal of having caught the black plague. This virtually always meant certain death.

It has been estimated that by the end of the fourteenth century the black plague had decimated the total population in Europe by up to 60%. It took the region 150 years to recover and the disease would remain as a threat until well into the 19th century.

It's not difficult to see why “God bless you” has remained a firmly entrenched social tradition ever since.

There is a clear parallel with what's happening in today's financial markets. As leading indicators have started to roll over, and with many kinds of problems and worries haunting major economic zones across the globe, few experts are still doubting the global economy has sneezed.

What does it mean? Will the world experience a rather mild form of a cold, or are we looking towards something more sinister?
Economist Lakshman Achuthan, who specialises in leading economic indicators, has sought extra-media exposure these past weeks as various leading indicators published by the company he co-founded, the Economic Cycle Research Institute (ECRI), continue to point towards a significant slowdown for the US economy from mid-year onwards.

Bottom-line, reports Achuthan, even though some of ECRI's leading indicators are now at levels last seen in late 2007, it remains yet to be determined whether the US economy will dip back into zero or negative growth later this year or in 2011. As things stand right now, ECRI is only prepared to forecast growth will dip significantly.

During his tour of US media, Achuthan also made one very important admission: it is impossible to know yet whether the US economy is heading towards a double-dip recession or whether the world's largest economy is simply experiencing a mid-cycle economic pullback from a stimulus-boosted GDP number late last year.

This is because all slowdowns start off in a similar fashion.

Hence my comparison with the bubonic plague in Europe: even though the plague peaked in the middle of the 1300s, and it never reached similar levels of devastating impact, this would not stop the disease from flaring up throughout centuries to come. More importantly, whenever someone sneezed until the 20th century, it was not possible to know whether the disease had made a come-back, or whether it was simply because of a cold.

For equity markets, the different possible scenarios represent all relatively predictable outcomes. If the global economy has merely caught a cold, share prices will likely hold up well and they might even regain their uptrend later in the year when it becomes clear that no major disasters await around the corner.

In case of any of the two other scenarios, however, bigger negative impacts should be expected. Last week, I calculated that earnings expectations for the companies that make the ASX200 (more than 90% of total market capitalisation of the Australian Share Market) would have to decline by 6% on average to put the index on an average FY11 multiple of 14.

This suggests there would be practically no room left for capital appreciation, all else being equal. (Note: projected average EPS growth would have to fall to 13% from 19%).

However, it is feasible that were earnings expectations to decline by such magnitude, investors would likely respond by accepting lower multiples only, which would indicate overall support for the market would shift to lower levels.

Following recent profit warnings from companies including Caltex (CTX) and Macquarie Group (MQG), the underlying trend in earnings expectations for ASX200 companies is now firmly negative. Australia has been leading the rest of the world and earnings trends in other regions, including the US and Asia, have now equally reversed.

While this does not mean FY11 forecasts in Australia will be reduced by at least 6% on average in the year ahead, it does indicate share prices could well remain under pressure for a while to come. Historically, share prices do not tend to respond favourably when confronted with falling expectations for corporate earnings as well as falling forecasts for economic growth.

This was once again confirmed by the latest historical data analysis conducted by global market strategists at UBS. Taking guidance from the US manufacturing purchasing managers' surveys*, with the research going back to 1950, I have summarised the research done by UBS strategists into four simple and easy to understand rules:

1.) If the US ISM index is below 50 but expanding, buy equities
2.) If the US ISM index is above 50 and expanding, buy equities and commodities
3.) If the US ISM index is below 50 but contracting, cash and bonds are the better performers
4.) If the US ISM index is above 50 and contracting, cash and bonds are the better performers

Right now the US ISM index is still above 50, but the index is coming off readings above 60 and likely to continue trending lower. History shows, this is usually not a good time to bet on equities performing well.

Two important things need to be pointed out. While history shows equities tend to respond negatively to prospects of lower earnings and lower economic growth, even more important is the rate of decline. In other words, equity markets should still be able to move sideways or gradually higher in case of rather mild reductions in corporate earnings, economic growth and US ISM readings.

Secondly, history also shows the above is especially true when the US employment picture improves. This is why strategists, such as the ones at UBS, refuse to give up on equities altogether for the year ahead. Global market strategists at UBS believe we have entered a period when leading indicators have peaked, but labour markets should soon start improving. The net balance of the two, reports UBS, is that “risk” should still beat cash and bonds in the year ahead.

UBS strategists can fall back on historical data to support their view, but they cannot guarantee that yesterday's sneeze will not ultimately end up as something worse than just a cold.

*Supply managers' surveys in the US are conducted by the Institute For Supply Management, hence why everybody talks about the monthly US ISM index.

Rudi Filapek-Vandyck is the Editor FNArena. This story was originally written and published on Monday, 28 June, 2010.

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