Subprime after-impact:Bumpy Ride Ahead?

USA has ended the year 2007 with lot of uncertainties and on a negative note. It may not have been the best of the times for investors, but the market downturns have been cushioned by an equally good year in Asia. Year 2007 has been nightmare on account of the subprime breakdown and is touted to be the worst times for US financial institutions. Though 2007 earnings for the US were variable, when the subprime blew off in the summer of ’07, markets started to tumble and take the heat on. The subprime provided a perfect catalyst for an US recession to set in with global analysts sitting with fingers crisscrossed. It has been observed that there have been a consistent slowdown in US earnings growth since 2004, though the S&P 500 forward P/E ratio remained at 17x last year. US investor sentiments have been hit hard due to the subprime spill over as housing is already under recession and home prices are slated to remain weak this year. USA is still the largest economy in the world and consumers make up about 70% of the US GDP.

Subprime has revealed that there are some better out there!

Earnings growth in US financial sector was down by about -44% in the fourth quarter of 2007. Bigger financial institutions like Citi bank and Merrill Lynch have been writing off huge subprime backed losses as did Bear Sterns and others last year. Their balance sheets look poorer on account of their risky investments that they made in subprime backed bonds and assets. Overall, the year 2008 has started on a weak note and high volatility in the equity markets. Out of this chaos, Asian emerging markets like India and China have come out as most attractive investment destinations in the regional markets in 2007-08.

It is a natural phenomenon that markets usually overreacts to news. Market price movements are also correlated to their long term fundamentals and as such, bad news spilling over the markets usually creates volatility price movements. The impact of subprime has been one such catalyst to bring in price swings in stock markets across the globe. When we track the performances of regional equity markets in 2007, it reveals that MSCI Asia ex-Japan returned 60.9% from 2003-2006, and 29% in 2007. Overall, MSCI ex-Japan returned 107.6% from 2004-07 while US S&P 500 returned 13.3% overall, and -1.6% in 2007. These shows off the potent rippling effect that subprime can spell over the global equity markets, and how investors should take a more defensive positions in equity investments.

Market Evaluation after Subprime Fall-out:

Europe remains the cheap out of most equity markets with a P/E ratio of 15x. ECB(European Central Bank) forecast a GDP growth of 2% in 2008 as a cautious note to a possible subprime impact and US recession in 2008. The headline Inflation returned to 2.5% and there are certain possibilities that the Euro zone could face the heat of subprime and the cold of US meltdown. Challenges in Euro zone are mainly due to € appreciation (strengthening of euro) causing exports to become more expensive. Another factor is the rising food and oil prices putting up inflationary pressures on the Euro zone economies.

Moving to the mid-east, lower production by the OPEC, strong demand from India and China combined with supply constraint has pushed the price of oil higher up to nearly US$100/brl. Analysts expect to see a tighter oil market in 2008 on account of uncertainties revolving the oil market and crude oil productions growth rate. The mid east economies have been diversifying fast into other non-oil based industries, like infrastructure, Banking and Finance, entertainment cum logistics and aviation hub.

Developing Asian equities are stated to have P/E ratios of 15.2x and 13.8x in 2008-09. As half of the emerging markets are developing Asian economies, global investors tend to diversify into these markets. On earnings outlook, Asia-ex Japan equity funds having a P/E ratio of 16.7x is expected to grow by 15.7% and 11% in 2008-09 respectively. But, with appreciation of Asian currencies like SGD, Indian Rupee and Thai baht, it is hurting the export competitiveness of these countries. The good point to note is that these countries have stronger balance sheet and healthy forex reserves in contrast to the last Asian Financial Crisis in 1997-98. Economies that are heavy producers of electronics products, for example, Korea, Taiwan, China, Singapore, Thailand and Hong Kong that produce semiconductor chips and digital appliances are likely to be hit by a US slowdown. On event of the subprime impact, the ‘4 Asian Tigers’ are expected to slow down by 4.5 % in 2008, although Emerging Asia is likely to grow by 9.2% and 8.3% in 2008-08. Domestic spending, infrastructure boom and intra-Asian trade is expected to keep up the pace of economic expansion in the event of a more volatile and bumpy year for investors.

Sources:
Fundsupermart.com, Bloomberg.com, Investopedia.com

Right Horizons Research Desk