Friday, February 5, 2010

The case for equities

Despite the strong gains off the March lows, we continue to expect equity markets to grind higher and outperform low-yielding government bonds and cash. Three main pillars of our constructive outlook include: a robust earnings recovery, continued accommodative policies, and still- reasonable market valuations.

Our overweight stance on equities over the past several months has been predicated on
our expectations for a strong and above-consensus earnings recovery. In the current
4Q09 reporting season, we expect at least USD 17 of S&P 500 earnings – 4% above
current bottom-up consensus expectations. Largely due to easy comparisons versus
4Q08, when financial sector profits were devastated, we expect profit growth this
quarter to be explosive at 200%. This positive year-over-year earnings change will represent
the first quarter of growth since June 2007, snapping a post Great Depression record of nine consecutive quarters of negative earnings on a year-over-year basis.

Part of our near-term optimism for earnings is based on the seemingly conservative expectations for the quarter. Consensus estimates currently imply a 3% sequential rise
(i.e., quarter over quarter) in 4Q non-financial earnings. This would be a material deceleration
from the 10% and 13% sequential non-financial earnings growth reported in 2Q (when real GDP contracted by 0.7%) and 3Q (when real GDP grew 2.2%), respectively. Given our assumption that real GDP grew by roughly 5% in 4Q, these consensus estimates appear far too conservative. However, after two consecutive quarters of betterthan- expected earnings results, good equity market returns in the weeks prior to 4Q earnings reporting season and share price weakness in the face of recent good earnings results, investors seem to have been
largely anticipating the good news. We view the recent equity market weakness as temporary
and expect equity markets to recoup recent losses as the year unfolds. Recent equity market weakness has also been exacerbated by concerns about tighter monetary policy in China. We view this concern as overblown. Despite some tightening of monetary policy in China, the banking authorities are still targeting double-digit loan growth in 2010.

Looking out to 2010, we raised our estimate for S&P 500 earnings from USD 78 to
USD 80, representing earnings growth of 29%. The bottom-up consensus stands at
USD 78.50. We also introduced our 2011 estimate of USD 92 (bottom-up consensus is
at USD 95, but the quality of estimates two years out is low, see Figure 1).

Unprecedented stimulus – a tailwind in 2010

The US government responded to the financial crisis by unleashing an unprecedented
amount of fiscal spending and monetary stimulus, which has cushioned the blow of
the recession and is now contributing to the recovery. Only during World War II has the US
federal budget deficit (as a percentage of GDP) been greater than it is now. This stimulus
is another major pillar behind our positive view on equities. The same is true for
monetary policy. The Federal Reserve has lowered the Fed Funds rate to a range of 0%
to 0.25%, the lowest policy rate in the history of the Federal Reserve. So even as banks
are likely to remain saddled with loan losses, the current zero interest rate policy and steep
yield curve allows banks to essentially “earn their way out” of their deep capital hole by
borrowing very cheaply and benefiting from strong net interest margins. On a broader
macro scale, low borrowing costs induce capital investment as it boosts the net present
value of investment projects. Additionally, for investors, low interest rates create
favorable relative return conditions for stocks compared to fixed-income alternatives. On
top of this, the Fed has provided unprecedented liquidity to the financial sector by
purchasing some toxic securities as well as US treasuries and US agency bonds (Fannie
Mae and Freddie Mac bonds). These actions are aimed at reducing borrowing costs for
businesses and consumers. The scale of the Fed’s purchases can be seen in the dramatic
growth in the monetary base.

ubs investors guide 2010

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