Considering multiple attrition

Ominous current events dominating headlines recently are likely reflected in equity valuation. Price-earnings ratios, are a reflection of confidence and with what’s going on, confidence in the future is waning. While I remain optimistic, I must recognise that the pattern of negative events and a subdued growth outlook in the developed world may mean that historical multiple ranges could be undergoing downward adjustment.

We’re dealing with a ‘reversion to the mean’. The world has become more complex, more competitive and perhaps more corrupt. It may have always been this way but the reporting wasn’t as good in the past as it is now. Economies have become more indebted and governments, certainly in the developed world and perhaps also in the developing world, have become dysfunctional. These qualitative factors would argue that multiples should be lower as well.

With the background for equities looking bleak, it’s useful to explore positive scenarios. The pattern of both the economy and the market over the past two years has been for the first quarter to be positive, the second and third to be weak and the fourth to be strong. Could that be repeated this year?

I believe the second half will be stronger than the first, but business leaders are reluctant to make longer-term decisions about adding workers and capital spending for three reasons. First, they are having trouble assessing the implications of Europe’s lack of a long-term solution to its debt problems. Second, the Affordable Care Act and the Fiscal Cliff have clouded the economic outlook for 2013. Third, the negative presidential campaigns of both parties have drained some hope out of those who would think that leadership in Washington will improve no matter the election outcome.

China’s second-quarter real gross domestic product (GDP) of 7.6 per cent takes the ‘hard landing’ possibly off the table for now, although critics question the accuracy of the figures. The most important cause of uncertainty is Europe, where significant structural change to resolve the debt crisis is needed. Markets were reassured a banking union agreement was reached several weeks ago, but it will take time and even that step doesn’t address the fundamental problems.

Spain and Italy could continue to borrow at rates that are unsustainable in the long term but their credit markets aren’t open to the private sector. Germany and other austerity hawks have softened their stance on deficit reduction for the weaker countries but recession looks likely for Europe this year and next with high unemployment possibly leading to the social unrest.

The European Stabilisation Mechanism and the European Financial Stability Facility can provide temporary relief to Spain and Italy to keep the governments in operation as deficits are incurred, but these are finite resources and weaker countries will only become viable when growth resumes, which may take some years. We’ve probably seen the last of the Long-Term Refinancing Operation. The banking union and tighter banking supervision is a positive step but isn’t enough. Deposit insurance will be needed to prevent runs on banks. These measures will enable the weaker countries to “muddle through” into next year when financial problems will intensify again.

Draghi said that the ECB will do “whatever it takes to preserve the euro and it will be enough.”

We all know that Europe ultimately needs fiscal and political union, such as we have in the US, although that arguably hardly works. Critics state that a political union is impossible because of language and cultural differences. Even then, no politician in Europe is capable of convincing people there that such convergence is a good idea, and a strong stance on the issue could be terminal to one’s political capital.

I now believe that there may be major EU changes as soon as next year. Greece and Portugal aside, I’m worried about Italy and Spain. I thought that the stronger countries recognised they had a lot to lose by an EU break-up and they had the resources to carry the weaker countries through a transition period. I now think the transition period could be infinite and the stronger countries can’t tolerate the profligate ways of their troubled neighbours who lack the political will to force the necessary changes.

Although France is working to help solve the financial problems of the weaker countries, it has plenty of its own. Its government spending is more than 50 per cent of GDP, unit labour costs are rising and taxes are high and going up. Aside from the financial needs of the governments themselves, the banks in France, Italy, Spain, Portugal and Greece will require almost a trillion euros to cover debt rollovers, loan losses and Basel III capital requirements. Where will all this money come from? Stronger countries will be able to borrow money from the ECB because they can demonstrate that they can pay it back. Weaker countries may have to leave the EU and print money to sustain their economies. It would be a turbulent period and we’re likely heading there.

In the end, a break-up could be positive. Establishing a union of the stronger countries with weaker ones on their own will result in dislocations but a major cause of uncertainty would be removed from markets. There are two alternative outcomes. Germany and other financially strong countries separate from the EU, reverting to their original currencies. This would leave the weaker countries free to devalue the euro, increasing their competitiveness and reducing the value of their historical obligations. The second alternative is for Germany to become the undisputed leader of the Union, where it would determine fiscal policies for others, enabling it to issue low-interest euro bonds to finance the weaker countries.

While I’m apprehensive, we could see US equities rise before year-end and some real values may be developing in Europe over the next year. In America future market appreciation may be more in line with earnings growth, meaning that double-digit returns from the indexes will be hard to come by. Effective asset allocation will be more important than ever.

The writer is vice-chairman of Blackstone Advisory Partners LP