2 major factors have weighed on equity markets over the last months: the possibility of a financial crisis and the risk of an economic recession in the United States. What is the current situation on both fronts and what are the implications for the stock markets?

1. Financial crisis:

The alarming deterioration of the situation in the credit markets led the US authorities to take some unorthodox measures in March:

• the Federal Reserve provided a temporary 6-month lending facility to primary dealers (this kind of facility is usually reserved for depository institutions);
  
• it allowed banks to use a wide variety of (illiquid) securities ( including Mortgage-Backed-Securities) as collateral in exchange for borrowing (liquid) Treasury securities;
  
• it continued to ease its monetary policy;
  
• it orchestrated the take-out of Bear Stearns, and in doing so, signalled that it would not allow a major US investment bank to fail;
  
• the government reduced the capital requirements for Fannie Mae and Freddie Mac, allowing these Government Sponsored Entities (GSE) to purchase or guarantee about $2 trillion in mortgages this year;
  
• in a letter posted on its website, the SEC offered financial institutions the possibility to abrogate the mark-to-market ruling if market prices are the result of a forced liquidation or distressed sale.

The result of these actions has been to improve liquidity in the credit markets and to stop the fall in the price of high quality assets. They have also produced a 15% rise in the share price of financial companies. What they haven't done is to address the main problem of falling house prices that place an increasing number of homeowners in a negative equity position, leading to a rising number of foreclosures and further downward pressure on the value of residential-related debt instruments. (There are however proposals in Congress aimed at helping struggling homeowners).

2. Recession risk:

In the fourth quarter of 2007, U.S. GDP grew at an annualised rate of 0.6%, a sharp slowdown from the 4.9% rate of the third quarter. Most of the statistics already published for the first quarter of 2008 are not encouraging. The most worrying is the deterioration in the labour market, with the US economy losing 232,000 jobs and unemployment rising to 5.1% in March, from 4.4% in March of last year. The decline in employment increases the risk of a significant weakening in consumer spending in an environment of falling house prices, high debt levels and low savings rates. One should also note that given the rise in energy and food prices, inflation is now running ahead of the growth in wages. On the positive side, US corporations are generally in good shape with low inventories and debt levels, while the depreciation of the dollar is boosting exports. These factors are however not sufficient to prevent a sharp economic downturn if private consumption, which represents over 70% of U.S. GDP, weakens significantly (tax rebates will however temporarily boost disposable income in the second half of this year).

To sum up, there is still the threat of a vicious circle between the financial crisis and the economy. Rising unemployment will lead to more mortgage delinquencies and foreclosures, which will in turn see an increase in the problem assets that are plaguing the financial system. Assets writedowns will thus continue to erode bank capital and will weigh on the banking sector's ability to make loans. The negative economic impact is irrefutable.

One should also note that the credit deterioration seen until recently occurred without either interest rates or unemployment rising. With the poor jobs data in the first quarter, there is now a risk that the largest share of the mortgage market - prime mortgages - will start to experience losses. And credit losses will not be limited to mortgages. In a recession, all credit sectors (auto loans, credit cards, etc) are usually affected.

What are the implications of this vicious circle for equities? More specifically, are most of the risks already discounted given that stock prices have fallen by some 20% since October?

Within the equity markets, there have been several underlying trends in the last months:

• a bear market in financial stocks;
  
• an onging bull market in the most global sectors like energy and commodities;
  
• a mild correction in the rest of the market.

To illustrate this point, one can look at the year-to-date performance of 3 stocks from the DJ Stoxx 50 index : BHP Billiton (commodities, +14%), Nestle (food, -1%) and UBS (banks, -32%).

This situation is reminiscent of the bear market of 2000-2003 which started out as a TMT (Technology-Media-Telecommunications)- only affair. It was only much later, when the recession risk increased, that the rest of the market was seriously impacted. Similarly, the current bear market has been concentrated on financials. The relative strength of the market outside financials is evidence that investors have mainly responded to the financial crisis, not to the risks of a sharp slowdown in economic growth.

When assessing the outlook for stock markets, one should therefore distinguish between the financial sector (which has fallen significantly) and the other sectors (which haven't). There may be a possibility that the former has bottomed out in relative terms, although with lingering concerns of further large write-downs and shareholder dilutions, it is difficult to imagine that the financial sector will perform well in absolute terms. The more important question for many investors is whether, similar to 2000-2003, there will be a two-stage bear market with a sharp fall in the non-financial sectors. The answer to that question depends on whether there will be an earnings decline and the extent of such a decline.

When looking at the ratio most commonly used to determine how expensive equities are, the P/E (Price divided by Earnings) ratio, most major stock markets look attractively valued. According to data from Morgan Stanley, the P/E ratios for the US, Europe and Japan are 16.7, 11.5 and 14.2 based on trailing 12 months earnings. These numbers compare favourably with their long-term average and seem to suggest that, at least for Europe and Japan, much of of the bad news is already discounted in current stock prices.

The problem with using the P/E ratio is that the denominator in that ratio, i.e. earnings, is currently very high. Starting in 2001, companies in every region of the world have experienced abnormally high earnings growth. To a large extent, the source of this earnings growth was profit margin expansion. Today, these profit margins are well above their long-term average. History shows that each time this happened, profit margins have declined and fallen below that long-term average before rising again. To quote the legendary value investor Jeremy Grantham, chairman of Boston firm Grantham Mayo Van Otterloo (GMO)," Profit margins are probably the most mean-reverting series in finance.If high profits do not attract competition, there is something wrong with capitalism."

Stock market valuations might therefore be higher than they appear if only P/E ratios are taken into account. It therefore makes sense to look at other valuation measures - such as Price/Sales or Price/Book value - which get round the high margin problem. On these measures, stocks look less attractive and are certainly not priced for major earnings disappointments which one would expect should a sharp economic slowdown unfold. According to Morgan Stanley, for these ratios to reach their 1990 (banking crisis in the US) or 2003 (latest bear market) troughs, stock prices in Europe would have to fall between 20 and 50%.

The 'relief rally' that started with the Bear Stearns take-out and has seen stock prices rise by some 10% since their mid-March lows may continue for a while longer, especially if the credit markets start to regain some stability. If this rally is to evolve into a lasting upturn, investors will however need to be able to look across the valley of economic weakness and financial problems to better times in late 2008/early 2009. This seems premature at least.

From an investor point of view, it makes much more sense to start thinking about the kind of long-term environment we're in, rather than trying to predict short-term fluctuations in stock prices. The deleveraging cycle will lead to sub-par economic growth in the United States in the years to come. A US recession would clearly have an impact on the rest of the world but economic growth in the developing countries should remain strong because of rising domestic consumption, infrastructure spending and intra-regional trade. The transition from an US-led to an emerging markets-led global economy will therefore continue. Investors should buy companies that are likely to benefit from that transition.