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Investor appetite for risk assets back in vogue. Is the worst over?

March 2016

March 19, 2016 | 11:00 | Dubai

The cautious tone from this week’s FOMC meeting has moved market expectations back down towards just one rate hike this year, giving a further boost to a range of risk assets following the ECB’s stimulus package last week. Global equities, up over 2% over the past week, have now recouped all of this year’s losses, while EM equities are up nearly 5% year to date, as per the latest report by the Institute of International Finance (IIF). The Fed’s dovish tone has also contributed to calmer market conditions, as volatility subsides. Credit spreads continue to narrow, most notably in emerging markets. With relative interest rate support ebbing, the U.S. dollar is down nearly 2% this week, posting its sharpest two-day drop since 2009. Brent futures pushed through $40/barrel for the first time since December, with most other commodities following suit.

With the search for green shoots getting further impetus, it is worth taking a fresh look at equity market valuations in a longer-term context. Forward price-earnings ratios have risen sharply from mid-January lows, propelled by a combination of higher prices and downward revisions to earnings estimates during February (about -1.5% for mature markets, and -3% for emerging markets). This has left forward P/Es well above their average levels over the past decade, even for emerging markets. In other words, it has become harder to make the argument that stocks are cheap. Trends in corporate profitability don’t offer much reassurance, IIF report said. While return on equity (ROE) for U.S. and Japanese firms is above or near average levels at present, it is sub-par almost everywhere else. For the Euro Area, banking sector profitability remains a particular source of concern, with ROE now near 6%. Across emerging markets, weak demand, the slump in global trade, and rising wage and unit labor costs in many countries have all hurt profits. Many firms have also been pursuing top-line revenue growth, cutting prices in the hopes of gaining market share. Over the past two years, higher borrowing costs (both in local currency and USD) have also weighed on EM corporate profits.

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