Equities still have relative valuation appeal but volatility is on the rise

Cash / Fixed income

We continue to view cash and government bonds as a hedge against an adverse economic outcome.

In that respect our short duration bias offers protection against both recession and inflation fears. A longer bond positioning would not only be vulnerable to inflation fears, but would also offer little value as real rates have been driven down by massive flight-to-quality flows.

High-grade credit - particularly in major financials - offers some tactical opportunities. While equity investors will likely suffer further, as banks’ earnings are revised down, the balance sheet risk is limited by the abundant liquidity available for recapitalizations.

Equities

The relative valuation appeal of equities remains compelling, even in our slowing - but not collapsing - earnings scenario. That said, for the first part of 2008, markets will swing between fears of recession and additional writedowns on the one hand, and reassuring non-financial corporate news on the other. In this more volatile environment, not only are we reaffirming our preference for visible growth stocks, but we are also considering various measures to limit downside risk.

Regionally, we maintain our preference for Europe vs. the United States, essentially because of the US-centric nature of the financial crisis and related negative news flows. We also confirm our structural conviction with respect to emerging markets, but suggest some diversification from China into Russia, on valuation grounds.

Alternatives

Attractive supply-demand trends, due notably to emerging economic growth, global liquidity, and long-term dollar depreciation, justify our exposure to commodities - with the exception of industrial metals, which are vulnerable to the US construction downturn.

Currencies

We are retaining our long-term bearish view on the dollar, largely due to the gradual shift away from a dollar-centric world. That said, dollar bearishness recently reached extreme levels, paving the way for a short-covering rebound into - seasonally positive - January.

The Subprime rescue package - not a panacea!

Amid slumping housing market data and relentless announcements of bank writedowns, President Bush unveiled a subprime rescue plan on December 7. This plan, negotiated by Treasury Secretary Henry Paulson, aims to help subprime borrowers facing mortgage rate resets over the next two years that they will not be able to afford, thus containing the rise in payment defaults and ensuing foreclosures.

Up to 1.2 million borrowers are targeted by the plan, split into two similar-sized groups. The first group, consisting of borrowers that are current on their mortgage payments, have a decent credit score (FICO above 660) and a loan-to-value ratio under 97%, will be eligible for refinancing into a fixed-rate loan. The second group, consisting of borrowers that are also current on their payments but with a lower credit score and less than 3% equity in their home, may be offered a loan modification that freezes the existing mortgage rate for a period of five years.

From the equity market’s perspective, the question is whether this plan can put a halt to the spiral of subprime defaults/rating downgrades/CDO writedowns that is plaguing the financial sector. Assessing this requires an understanding of how CDOs are created - as illustrated in the chart below.

The first step of the process (or so-called "Generation 0") consists of mortgage issuance. Some 14% (USD 600 bn in 2006) of this is represented by the subprime segment. The second step ("Generation 1") securitizes these subprime mortgages into subprime residential mortgage-backed securities (RMBS), by pooling them and then cutting out different tranches by level of risk. The losses resulting from defaults work their way up from the lowest to the highest (AAA) tranche. The third step ("Generation 2") turns pools of RMBS into CDOs. In the chart below, we illustrate the creation of mezzanine subprime CDOs, based on BBB-rated RMBS. Clearly, the AAA labeling of the higher tranches of such CDOs is misleading, since the underlying assets are nowhere near AAA quality.

Now to the rescue plan: if successful in limiting the rise in defaults on subprime loans, it should restrict losses to the lower tranches of the RMBS structure (and the related CDOs), and limit contagion moving up the RMBS structure. Will that mean less rating downgrades of the higher tranches? Unfortunately, the answer is probably "no", since the mortgage refinancings and rate freezes offered by the rescue plan will reduce the yield on the higher RMBS tranches, potentially driving more rating downgrades.

All told, it is not clear that this plan will help contain CDO writedowns at banks. While it may well limit defaults on subprime loans, it will not halt rating downgrades. Combined with the persistent illiquidity of the CDO market, this actually suggests further writedowns by financial institutions - particularly in the coming weeks as fiscal year-end books are audited.

Year-end exacerbating financial tensions 

The negative spiral described above plays a large part in explaining why, contrary to previous financial crises, risk aversion is exhibiting a second upleg (see chart). This development is worrisome, to the extent that the longer the crisis persists, the greater the risk of a material impact to the economy. That said the turn of the fiscal year is likely exacerbating interbank tensions, as institutions prepare for auditors to scrutinize their year-end positions, preferring to err on the conservative side when marking them to market (or model).

The Ted spread - which measures the difference between the interbank and risk-free rates (see chart) - is indeed larger on short maturities, i.e. just crossing year-end, than on a 6-12 month horizon. And the Federal Reserve seems to share the hope that tensions will abate after the year-end process, judging by its decision to cut Fed funds by "only" 25 bp at its last 2007 meeting and set up a new auction facility to provide liquidity directly to the banking sector around year-end.

Clearly, news flow from the heavy-weight financial sector is set to remain grim at least through the end of the annual reporting season, sustaining investors’ recession fears. Non-financial corporate news should, however, remain supportive thanks to solid balance sheets and continued economic growth outside the United States, notably in the emerging world. All told, volatility looks set to be high during the first part of 2008, as equity markets swing between these opposite viewpoints.

Notwithstanding this volatility, two factors support equities on a longer-term perspective. Relative valuation versus other asset classes remains appealing, provided earnings do not collapse. And - as has become clear recently with the Citigroup and UBS recapitalizations - tremendous liquidity stands to be provided by sovereign wealth funds, as detailed in the table below.