The question is at what point do equities start looking cheap. We think about markets and opportunities from an portfolio construction perspective. However, we appreciate clients want some context around current market prices so hopefully comments below help.

Have equities fallen far enough? Potentially not but they are more closer to the bottom than they were before today (the market is currently down -7.7%). From the recent high in late Feb-20, the S&P/ASX 200 is down by more than -20% (this number moves by +/- 5% everyday!), making this episode among the fastest market corrections. Clearly, on an equity risk premium basis a strong case can be made for equities, especially given we expect rates to go lower and stay lower for longer. In our view, this is may not be enough in the current uncertain environment to entice investors to take the risk. The other critical data point for consideration is consensus earnings estimates, which are looking increasingly vulnerable. In the table below, we have provided current consensus estimates for Australia (S&P/ASX 200), the U.S. (S&P 500) and Europe (STOXX Europe 600 Index). The European market is the most cyclical and therefore reliant on global growth – it is expected to deliver +5.1% earnings growth in CY20. 

Figure 1: Consensus sales, EBITDA & EPS growth estimates for key markets

First and foremost, the above table again reminds us the returns investors achieved in CY19 were based on multiple expansion (high PE multiples) and not improving underlying fundamentals (there was little earnings growth and in the case of ASX200 it was slightly negative). What drove the market rally in CY19 was the view that the stabilizing manufacturing PMIs (& broaderly other economic data) towards the end of CY19 will improve over CY20, backed by easy financial conditions (and diminishing trade tensions).

The outbreak of the Coronavirus has completely reversed (and then some) this bright spark in the global economy. In our view, the recent pull back (despite it being very sharp) was investors giving back these gains they pulled forward into CY19. Whether equities go lower from here will in part be driven by what consensus does with their estimates going forward. Currently consensus estimates are looking for fairly solid earnings growth over CY20 (approximately 7% in the U.S.), should the Coronavirus issue become protracted (that is, move into 3Q20 / 2H CY20), earnings estimates will need to be revised closer to 0% (and perhaps even negative if a recession materialises – as a rough estimate market earnings decline by approx. 15% during a recession).

Dissecting S&P/ASX 200 earnings estimates. In the table below we have provided ASX 200 growth estimates by sector (and included index weight of each sector as a reference). We highlight some sectors worth noting. Consensus is already expecting subdued earnings growth for Materials and Financials (driven by major Banks) for CY20 / CY21. But there have been minimal revisions to date due to the Coronavirus, in our view. Industrials are still expected to deliver earnings growth of ~9% in CY20 and ~13% in CY21.

In our view, one reason for this may still be due to the fact as of the Feb-20 reporting season, most companies had little visibility on the Coronavirus impact and, all else being equal, at the time disruption appeared to be minimal – hence outlook commentary was “monitoring the situation.” Industrials estimates could be vulnerable to downgrades (along with other sectors as well). On the flipside, significant stimulus by China and other governments to combat the virus could be very beneficial to the materials sector.

Figure 2: S&P/ASX 200 EPS growth estimates – sector breakdown

What’s in the price? This is NOT a perfect analysis (given the assumptions in it are static and markets are not!) but it is more to provide some colour. The current S&P/ASX 200 level (highlighted in yellow – last reading of today’s movement) suggests the correction has by and large moved the ASX 200 in line with current consensus earnings estimates if we use ASX 2000 long-term average PE-multiple (around 14.5x) – that is fairly valued (if earnings estimates remain the same for the rest of the year). In fact, the market is now slightly discounting the index on this basis.

However, If things deteriorate and earnings have to be revised to look like a Bear Case (e.g. earnings are revised to decline by -10% in CY20 and -5% in CY21), then using the long-term PE-multiple of 14.5x (which is a meaningful assumption given PE-multiples dropped below 10x during the GFC), the downside from current levels is another 10-15% [If this happens, the ASX 200 would have corrected ~40% from recent highs]. If you change a few assumptions (multiple & earnings), the numbers materially change hence the uncertainty around the current events. Investors need to watch out for company announcements.

*This article is just a snippet of the full article sent to clients of BanyanTree Investment Group. Find out more about them here.