Looking Past The Current Turmoil - Upgrading 12 Markets; Downgrading Europe

Having adjusted our earnings forecasts to better reflect the weaker economic outlook, equity markets remain attractive and we are keeping our "overweight" view on the asset class. Also, the poor year-to-date performance of equities translates to stronger potential upside for most markets from current levels, and we are upgrading our ratings on 12 equity markets as a result.

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

 

Table 1: Sharp Declines in August
Market	Index	MTD (Local Currency)	YTD (Local Currency)
Russia	RTSI$	-18.8%	-9.8%
South Korea	KOSPI	-16.6%	-13.3%
Europe	Stoxx 600	-15.0%	-18.2%
Asia ex-Japan	MSCI Asia ex Jap	-14.5%	-13.9%
China	Hang Seng Mainland 100	-14.3%	-15.0%
Emerging Markets	MSCI EM	-14.2%	-15.2%
Taiwan	TWSE	-13.9%	-17.0%
Singapore	FTSE STI	-13.8%	-13.9%
India	SENSEX	-12.9%	-22.7%
Hong Kong	HSI	-12.7%	-15.0%
Global	MSCI World	-11.4%	-10.0%
Japan	Nikkei 225	-10.5%	-14.0%
Brazil	BOVESPA	-9.3%	-23.0%
USA	S&P 500	-8.9%	-6.4%
Technology	Nasdaq 100	-8.5%	-2.5%
Thailand	SET	-8.5%	0.4%
Indonesia	JCI	-7.0%	3.7%
Malaysia	KLCI	-6.7%	-4.9%
Australia	S&P / ASX 200	-5.1%	-11.5%
Source: Bloomberg; Returns in index currency terms, excluding dividends and as of 26 August 2011

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).

Table 2: Revisions to Earnings Forecasts
	iFAST Estimates			Consensus Forecasts
Regional Markets	2011 EG	2012 EG	2013 EG	2011 EG	2012 EG	2013 EG
Asia ex-Japan	11.3%	6.7%	18.7%	14.6%	15.4%	12.2%
Emerging Markets	10.2%	9.5%	16.3%	16.8%	13.8%	11.5%
Europe	-23.0%	20.5%	10.8%	8.1%	12.6%	4.7%
Japan	4.5%	-4.4%	27.6%	4.1%	15.6%	22.8%
US	1.3%	7.5%	19.8%	17.0%	12.9%	10.5%
Single Country/Sector	2011 EG	2012 EG	2013 EG	2011 EG	2012 EG	2013 EG
Australia	18.9%	15.9%	12.6%	30.4%	10.3%	7.5%
Brazil	1.7%	17.1%	15.8%	14.9%	12.1%	14.5%
China	17.7%	8.7%	17.9%	19.0%	14.8%	13.3%
Hong Kong	9.2%	8.0%	13.8%	12.5%	14.5%	12.6%
India	9.5%	16.0%	14.0%	9.9%	17.0%	12.7%
Indonesia	17.2%	17.5%	13.9%	25.8%	20.0%	15.0%
Korea	16.3%	1.9%	17.6%	16.3%	14.4%	11.8%
Malaysia	-1.0%	8.3%	12.9%	6.9%	14.6%	11.0%
Russia	36.2%	5.7%	5.7%	50.5%	5.7%	0.1%
Singapore	0.9%	-6.4%	35.9%	6.0%	9.2%	13.9%
Taiwan	4.0%	2.8%	25.4%	11.1%	16.2%	8.3%
Tech (MSCI AC World IT)	2.5%	18.0%	20.0%	25.6%	14.4%	12.1%
Thailand	15.1%	12.3%	15.4%	25.8%	14.2%	10.8%
Source: Bloomberg, iFAST estimates; data as of 26 August 2011

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. 

Table 3: Valuations remain compelling
PE Ratios
Regional Markets	2010	2011	2012	2013
Asia ex-Japan	12.6	11.3	10.6	8.9
Emerging Markets	11.4	10.3	9.4	8.1
Europe	10.1	13.1	10.9	9.8
Japan	15.1	14.5	15.1	11.9
US	13.8	13.6	12.7	10.6
Single Country/Sector	2010	2011	2012	2013
Australia	14.7	12.4	10.7	9.5
Brazil	10.1	9.9	8.5	7.3
China	11.2	9.5	8.8	7.4
Hong Kong	12.0	11.0	10.2	8.9
India	14.9	13.6	11.8	10.3
Indonesia	18.9	16.2	13.8	12.1
Korea	10.4	8.9	8.8	7.5
Malaysia	15.3	15.5	14.3	12.6
Russia	7.7	5.7	5.4	5.1
Singapore	13.5	13.4	14.3	10.5
Taiwan	13.1	12.6	12.2	9.8
Tech (MSCI AC World IT)	15.1	14.7	12.5	10.4
Thailand	14.8	12.8	11.4	9.9
Source: iFAST estimates, Bloomberg; data as of 26 August 2011

Table 4: High excess yields indicate relative attractiveness of equities
Excess Yield *
Regional Markets	2011	2012	2013
Asia ex-Japan	5.7%	6.3%	8.1%
Emerging Markets	4.1%	5.0%	6.8%
Europe	6.4%	8.0%	9.0%
Japan	6.6%	6.3%	8.1%
US	6.4%	7.0%	8.5%
Single Country/Sector	2011	2012	2013
Australia	4.1%	5.4%	6.6%
Brazil	-2.0%	-0.3%	1.6%
China	6.7%	7.6%	9.7%
Hong Kong	8.3%	9.0%	10.4%
India	-0.9%	0.2%	1.4%
Indonesia	0.0%	1.1%	2.1%
Korea	7.6%	7.8%	9.8%
Malaysia	3.1%	3.6%	4.5%
Russia	10.1%	11.1%	12.2%
Singapore	7.0%	6.5%	9.0%
Taiwan	6.9%	7.1%	9.2%
Tech (MSCI AC World IT)	-	-	-
Thailand	4.3%	5.3%	6.6%
Source: iFAST estimates, Bloomberg; *excess yield based on 5-year sovereign bond yields

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).

Table 5: Strong Potential Upside Forecasted
Market	Estimated Upside by end-2013 (annualised %)
China	31.5%
South Korea	25.3%
Emerging Markets	24.2%
Hong Kong	23.2%
Asia ex-Japan	23.0%
Taiwan	23.0%
Brazil	20.8%
Technology	20.5%
Singapore	20.0%
India	16.0%
Australia	18.5%
Russia	17.9%
US	16.0%
Japan	11.4%
Thailand	10.0%
Europe	10.0%
Malaysia	9.8%
Indonesia	9.6%
Source: iFAST estimates; potential returns in index currency terms as of 26 August 2011

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.   

Table 6: Changes to Star Ratings
Regional Markets	Star Rating	Old	Rating Change
Asia ex-Japan	5 “Very Attractive”	4 “Very Attractive”	Upgrade
Emerging Markets	5 “Very Attractive”	4.5 “Very Attractive”	Upgrade
Europe	3 “Attractive”	4 “Very Attractive”	Downgrade
Japan	3 “Attractive”	3 “Attractive”	-
US	4 “Very Attractive”	3.5 “Attractive”	Upgrade
Single Country/Sector	Star Rating	Old	Rating Change
Australia	4 “Very Attractive”	3.5 “Attractive”	Upgrade
Brazil	4.5 “Very Attractive”	3.5 “Attractive”	Upgrade
China	5 “Very Attractive”	4.5 “Very Attractive”	Upgrade
Hong Kong	5 “Very Attractive”	4.5 “Very Attractive”	Upgrade
India	4 “Very Attractive”	2.5 “Neutral”	Upgrade
Indonesia	2.5 “Neutral”	2.5 “Neutral”	-
Korea	5 “Very Attractive”	4.5 “Very Attractive”	Upgrade
Malaysia	3 “Attractive”	3 “Attractive”	-
Russia	4 “Very Attractive”	4 “Very Attractive”	-
Singapore	4.5 “Very Attractive”	3.5 “Attractive”	Upgrade
Taiwan	5 “Very Attractive”	4.5 “Very Attractive”	Upgrade
Tech (MSCI AC World IT)	4.5 “Very Attractive”	4 “Very Attractive”	Upgrade
Thailand	3 “Attractive”	3 “Attractive”	-
Source: iFAST compilations

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.