14 January 2013

In the first week of 2013 the FTSE 100 closed above 6,100; a key technical resistance level which has been tested (but not breached) on a few occasions since May 2008. Similar positive technical themes are repeated elsewhere. For example the S&P 500 stands on the cusp of new highs since 2007, and is now just 6.5% from all-time highs.

The positive technical background is complemented by a useful fundamental background…

  • Monetary conditions continue to ease in the Eurozone
  • The US housing market continues to improve
  • China shows signs of economic recovery
  • US consumers will suffer tax increases following the fiscal cliff resolution
  • The US debt ceiling and sequestration spending cuts are likely to create volatility
  • Eurozone unemployment continues to rise
Investors look to earnings…

All eyes at the moment are on the earnings season. Analysts had modest expectations going into this season given the downbeat guidance from third quarter releases. Investors, on the other hand, have begun to bake some optimism into their expectations. The price earnings multiple on the FTSE 100 (using our preferred 12 month forward blended measure) has risen 1.2x since Mario Draghi's pledge to do "whatever it takes" to eliminate convertibility risk within the eurozone. That reflects a move from 9.9x to 11.2x earnings.

Since the end of 2009, during which time the market has lurched from risk on to risk off, the multiple has averaged 10.1 times.

Chart 1: Net Interest Margins at Financial Institutions

Wells Fargo reported the first results of the fourth  quarter earnings season and so are seen as a potential bellwether for the financial sector. The results beat expectations but analysts balked at the decline in net interest margins (NIMs). Whilst disappointing for Wells Fargo this could be troubling for the US at large; the inference being that the Federal Reserve, depressing bond yields, has diminished banks' ability to make money on from lending. 

The financial sector underperformed on Friday because of the results and, if true, this could have wider implications for the path of Federal Reserve policy. It appears however that while NIMs are below their average of recent decades, they are above the lows seen before the 1990s.

Wells Fargo's net interest margin is therefore unlikely to alter the path of Federal Reserve policy. Indeed, if anything, the modest disappointment on mortgage sales underlines flaws in the transmission mechanism which prevent low treasury and agency mortgage yields from lowering borrowing costs for the broader economy.

Wells Fargo's results are also important in terms of the guidance they offer for the market's overall valuation. Here it is notable that the S&P 500 is much more diversified in terms of the contributions it receives from different sectors towards this year's earnings growth than the FTSE 100 is.

Chart 2: Contribution to index earnings growth for the S&P500 and FTSE 100

Chart 3: Equity valuations relative to their average during the risk on/risk off years...

More important earnings information will therefore come this week. Some of the index's industrial heavyweights are reporting, such as General Electric, Intel, Schlumberger and United Health; along with the major financials (JP Morgan, Citigroup, Bank of America and Goldman Sachs and Morgan Stanley).

As far as earnings season goes the results have been mixed. The overall beats-to-misses ratio is positive: earnings are beating expectations in around 80% of cases; revenues are beating in 70% of cases. Only 27 companies have reported so far though with a further 40 due this week.

Valuations have forged ahead…

This year we have been reluctant to forecast valuation expansion with the fiscal ceiling negotiations and Italian elections looming in February. Both of these events have the potential to rock the market.

Polling continues to suggest that the Republicans are considered to be an unwelcome obstruction to US fiscal policy. However, when broken down to analysing issues, the US public actually seem to side with the idea of cuts to entitlements and the so-called Boehner-rule (that any increase in the debt ceiling be matched by cuts to spending).

Should the Republicans get their PR machine functioning more effectively they will almost certainly take this round of negotiations to the wire (and possibly beyond).

In the Eurozone, Silvio Berlusconi announced that in order to placate his Northern League allies he will not seek a fifth term as Italy's premier. Nevertheless, Berlusconi's coalition is making gains in the polls and the chances of an unstable coalition remain elevated. 

Once these events have been resolved we would expect that structurally higher valuations are justified but for the moment it appears the markets' rally may have become to discount a degree of stability which is not yet justified.

IMPORTANT NOTES
The information contained in this report represents an impartial assessment of the value or prospects of the subject matter. Graphs, performance data etc are as at the close of business on the day preceding the date of the note. The information contained in this report has been taken from sources disclosed in this presentation and is believed to be reliable and accurate but, without further investigation, cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Ltd. No Director, representative or employee of Brewin Dolphin Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in, or options on, the securities mentioned herein or may buy, sell or offer to make a purchase or sale of such securities from time to time. In addition, we reserve the right to act as principal or agent with regard to the sale or purchase of any security mentioned in this document. For further information, please refer to our conflicts policy, a printed copy  is available on request. The value of your investment or any income from it may fall and you may get back less than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio you should seek the advice of a qualified investment adviser. Brewin Dolphin Ltd, a member of the London Stock Exchange, authorised and regulated by the Financial Services Authority. Registered office: 12 Smithfield Street London EC1A 9BD. Registered in England and Wales no 2135876.

distributed by