The Hindu Business Line : Market View

It would be impossible or at least very unreasonable to ignore the credit crisis’s impact on earnings growth, which moreover is already quite apparent. We expect this crisis to continue to weigh heavily on the profits of US and European financial firms in the first half of 2008. We therefore do not think it very realistic to try to predict the performance of equity markets on the basis of the current consensus forecast of 14 per cent EPS growth for US firms in 2008, though we do expect earnings to pick up significantly in the second half of the year.

Since we predict growth below potential in the developed countries and at potential in the developing economies, and since listed Western companies already earn a third of their sales outside their home country, we feel it would be more realistic to assume 4-5 per cent earnings growth in the developed countries, rather than the trend growth rate of 6-7 per cent.

The stronger fundamentals and momentum of the emerging countries, where the potential for productivity gains is far superior to that of the developed countries, will naturally enable stronger earnings growth than in developed economies. However, earnings will not be as robust as in 2007, due to the slowing of exports and less favourable monetary conditions.

Although the consensus estimate of 15 per cent earnings growth for the emerging markets is a little optimistic. it is certainly possible. On this basis it would, therefore, seem that the emerging world clearly once again offers the most attractive opportunities for equity investors, when adjusted for the higher risk, of course. Although this may very well again prove to be true in 2008, the case for emerging equities is certainly not as strong as it was in 2007. For the first time since the equity market began its bull run, we do not expect any substantial difference in the performance of the emerging and developed markets, particularly after adjusting for risk.

Indeed, while the increase in share prices in the developed markets has essentially been driven by earnings growth (with P/E ratios being more or less flat) that of the developing markets has also been fuelled in large part by an often considerable expansion of P/E multiples, which now equal or even exceed those of the developed markets.

In other words, although there is no doubt that emerging equities still offer much upside potential, this is now likely to depend increasingly on earnings and, therefore, on cyclical considerations rather than on longer-term structural factors, which of course are still valid but have been largely priced into emerging market valuations. As for equities in the developed markets, they can return 7-9 per cent excluding dividends, based on P/E expansion of about 5 per cent, since their valuations reflect no irrational exuberance. A clearer and more positive view of the economic and financial environment, as a result above all of the easing of monetary policy, will be the catalyst for this re-rating, which may even begin before the second half of the year.

BNP Paribas Asset Management

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