Global Equity Strategy-- On a knife's edge ::Credit Suisse,

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Global Equity Strategy ----------------------------------------------------------------------------------------
On a knife's edge


● We reduce our EPS growth forecasts for 2011 to 12% (from 14%)
in the US and 7% (from 12%) in the Euro-area (6% for both in
2012) and take our 2011 year-end target for the S&P down to
1,350 from 1,450 previously (1,400 for end-2012), on weakerthan-
expected growth. Yet, we stay overweight equities (having
upgraded on 14 June at slightly higher levels), due to:
● Modest growth reacceleration. We believe US GDP growth will
recover to circa 2%, from 1.1% in 1H.
● Relative valuation looks compelling: The ERP on consensus
earnings numbers is 6.8%, and even on post-1920 trend earnings,
it is still 5%, while ISM/credit spreads suggest 4.7% is warranted.
● Two big risks: (1) Europe: Key changes in principle occurred two
weeks ago, but we believe the ECB/EFSF has to start buying
Spanish and Italian bonds before markets are calmed; (2) US
fiscal tightening will be 2.5% of 2012E GDP if payroll tax credits
are not renewed.

There have been only three occasions since 2003 when real
rates have fallen while inflation expectations have risen—and this has
typically been a positive for equities

What is unusual in this sell-off?
There are two unusual aspects about the recent sell-off: Index-linked
bond yields have fallen and inflation expectations have risen
marginally (and equities are an inflation hedge). This matters for
equities, given that they are real assets, in a way that the appropriate
discount rate is the real rate. Moreover, the fall in real bond yields also
lowers private and public sector funding costs and, above all,
discourages savings.
We see five critical issues at the moment: (1) The global mid-cycle
slowdown. (2) The situation in peripheral Europe, and the ability of
European banks to access term-funding from private markets (or even
the ECB). (3) The end game in peripheral Europe, now that Bonos
and BTPs are bordering on unsustainable levels. (4) The degree of
fiscal tightening in the US next year, which on current polices looks to
be a very high 2.5% of GDP. (5) Emerging market overheating.
Why we believe this is just a mid-cycle slowdown, with a
recovery to circa 2% in US GDP growth: (1) Macro surprises are at
depressed levels, which in the past have been consistent with ISM
new orders troughing within two months. (2) The CS Basic Materials
Index is consistent with a small uptick in lead indicators and growth.
What if we are wrong and the US suffers a double dip? We believe
that if growth is much weaker than we think, most major central banks
will engage in QE. The problem is that rising inflation expectations
might prevent QE from being implemented. However, with 70% of
inflation coming from the labour market and wage growth still muted in
the developed market, we do not see inflation as a constraint to
further QE: the wage component of the US employment cost index is
rising at only 1.5%, and UK wage growth is just 2% and 2.3% in
Europe. With productivity growth in line with trend, that leaves core
unit labour costs falling in the US and rising marginally in Europe.
We believe the end game is negative real rates (across the yield
curve), alleviating debt service burdens and forcing investors to take
on risk, reducing the saving ratio and revaluing GEM currencies. We
think QE in the UK and Japan looks likely; we attribute a 50% chance
of more QE in the US.
We revise down our EPS growth and index targets – but
remain overweight equities
We revise our forecasts for EPS growth in the US for 2011 and 2012
to 12% and 6% (from 14% and 9% previously) and in the Euro-area to
7% and 6% (from 12% and 9% previously), on the back of the weaker
macro outlook.
Relative valuation looks compelling. The ERP on consensus
earnings numbers is 6.8% – and even on post-1920 trend earnings it
is still 5%, while ISM/credit spreads suggest 4.7% is warranted. Over
the last week, real bond yields have fallen, inflation expectations have
risen. Tactical indicators are mostly supportive, in our view.
Two big risks: (1) Europe: Key changes in principle occurred two
weeks ago, but we think the ECB/EFSF has to start buying Spanish
and Italian bonds before markets are calmed; (2) US fiscal tightening
will be 2.5% of 2012E GDP if payroll tax credits are not renewed.
Investment conclusions
We stay long of equities tactically and strategically. Within equities, we
continue to be underweight cyclicals as the P/B relative to defensives,
the price relative to defensives and net buy recommendations all
appear extreme. Importantly, we note that it is possible to have
defensive-led bull markets.