Weekly Broker Wrap: Recession Is Coming

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By Rudi Filapek-Vandyck

The eurozone is heading for recession, possibly as early as the final quarter of this calendar year, which starts next week. This is not my view, but one that is increasingly popping up in stockbroker research around the globe. And yes, sad to say but I have to admit: I concur. So the Big Question then becomes: will this affect the rest of the world and how badly?

Here opinions remain divided. Some experts at prominent household names including BNP Paribas, Societe Generale, Morgan Stanley and Royal Bank of Scotland have already warned their clientele to position investment portfolios for global recession next year, but this is as yet not a global consensus view. What does seem a prediction carried by an overwhelming majority is that the next few months will remain challenging for risk assets in general. Some strategists have all but given up on prospects for a sustainable rally between now and mid next year. US strategists at Morgan Stanley issued an eye catching report this week carrying the title "Hope is not a strategy". The strategists suggest investors should sell shares in any rallies because things are likely to get uglier before they get better.

Whether this is bad news depends on investors' portfolios, intentions and horizons. Market strategists at GaveKal, for example, believe crude oil "looks set for a sizeable reckoning", and yes, commodities across the world, including grains, industrial metals and precious metals have now started to follow equities into a relentless downward cycle. But GaveKal's Charles Gave also believes "the coming months are going to be one of the best times in investment history to accumulate good-quality equities".

Which is probably why the following quip seems so appropriate: how does one recognise an investment genius? He who has cash available at the end of a bear market!

A recession in Europe will have direct short term consequences, starting with a new loosening cycle for central banks in the region. Already, predictions are being made about pending interest rate cuts in Norway, Sweden, by the European Central Bank (ECB) and potentially across Emerging Markets in Asia as well. The jury is still out whether central banks in China and in Australia will join in too, but the obvious observation stands: there's a new trend in global interest rate forecasts and it is quickly gaining pace amongst the world's financial experts.

All this has made for some serious reshuffling in FX experts' forecasts and preferences. In Danske Bank's view, the underlying message for FX speculators has now become clear: sell the EUR against USD, GBP and NOK and sell AUD/USD and NZD/USD on days where there is relief on the stock market. Gone are forecasts of 1.15 or even higher for the Aussie against the greenback. Instead FX predictions are now mentioning "below parity for a while" and "targeting 90c".

The changed dynamic in FX markets has caught some experts by surprise. Macquarie, which as yet is only forecasting slower growth, not a recession anywhere, this week revised its AUD/USD forecasts upwards with negative implications for mid-tier and small oil companies in Australian in particular. In Macquarie's defense, the analysts do concede the immediate outlook for the Aussie does look wobbly on a three to six months horizon, but Macquarie maintains the view that stronger for longer will remain the theme for AUD in years to come (carried by ongoing strength for commodities prices in general).

Macquarie strategists also issued research based on historical data suggesting equity markets are -believe it or not- at present in a sweet spot with history showing the period from October to April tends to generate noticeably better results than the rest of the year. The Big Question remains, of course, with investors taking an ever so negative view on developments in Europe and on the outlook for the global economy next year, whether history will stay on course this time around as well?

Meanwhile, it would appear the stockbrokers' favourite pastime has turned into trying to determine how much downside is left for equities and for commodities, and how much negative news has already been priced in? On Goldman Sachs' assessment, industrial companies in Australia, including the banks, are now priced for no growth into perpetuity, which suggests value galore (see also GaveKal above). Strategists at Citi and at Deutsche Bank would like to agree, but as long as economic and earnings forecasts across the globe remain in a downtrend, there simply seems little valuation support, let alone a positive catalyst, is their argument.

Citi's call is that earnings forecasts will have to stabilise first before share prices can do so too. Deutsche Bank believes earnings forecasts for industrial companies in Australia will settle in the 5-10% growth range for FY12. As current consensus forecasts assume 14% growth, this implies more adjustments need to be done by stockbroking analysts. Data provided by Deutsche Bank also suggests earnings estimates in Australia are currently battling with more downward pressure than elsewhere, with one sole exception: Europe. I'd like to put forward this probably explains as to why the Australian share market is significantly underperforming most overseas markets.

In a report on Australian small caps stocks, analysts at Credit Suisse predict that, as platonic shifts are taking place in and around Australia, formerly out-of-favour sectors could start outperforming. While acknowledging finessing the timing of this occurring is challenging, CS analysts suggest investors should put the following small caps on their radar: Virgin Blue ((VBA)), Adelaide Brighton ((ABC)), GWA Group ((GWA)), APN News & Media ((APN)), Wotif.com ((WTF)), Cabcharge ((CAB)), Programmed Maintenance ((PRG)), Flightcentre ((FLT)) and OrotonGroup ((ORL)).

In what might well turn out another case of bad timing, analysts at Citi initiated coverage on some junior copper companies this week. Citi remains positive on copper's longer term outlook, but the analysts also believe upside potential for non-producing junior companies doesn't stack up against the risks involved. Citi's advice for investors is to thus stick with actual producers PanAust ((PNA)) and OZ Minerals ((OZL)). The analysts also have a Buy rating for Sandfire ((SFR)) which is the exception amongst non-producers in the stockbroker's view.

Finally, I'd like to introduce the Rotten Tomatoes Award for research that simply isn't worth the paper it was printed on. Quant analysts at JP Morgan have tried to identify "fundamentally defensive" stocks in the Australian share market, but one quick look at the outcome of their hocus pocus with data is sufficient to know this is one piece of research that would have been better left unpublished. Any exercise that directs investors towards names such as Cochlear ((COH)), Fortescue ((FMG)) and Atlas Iron ((AGO)) is seriously flawed. I would like to think I am not the only one to see why.

The share price for Atlas Iron just lost more than a quarter of its value in only a matter of weeks, while the losses for shareholders in Cochlear are even bigger since April this year and it remains yet to be seen whether the share price won't reach for $40 first before clawing its way back to what now looks a near unimaginable $84. Compared with these two examples, the historically volatile Fortescue Metals -down from $6.75 earlier in the year to below $5 and falling- almost looks like a low volatility safe haven, but of course it isn't. One simply cannot change the inner nature of the beast.

Investors looking for safe havens need not look further than actual price action. Supermarket operator Metcash ((MTS)) is still trading around price levels from April, when the share market peaked, plus the stock is offering a fully franked dividend of 6.8%. Stocks like Telstra ((TLS)), Domino's Pizza ((DMP)) and ARB Corp ((ARP)) have held their ground as well. Maybe someone could explain JP Morgan analysts the true definition of "fundamentally defensive"? Unfortunately, we have seen too much flawed fairytale research of late. The Australian dollar is a new safe haven is yet another theory that was quickly exposed as myth, with the currency losing US6c in 48 hours.

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