Deutsche Bank Warns on Emerging Markets, Poor Equity Returns in 2012

Avoid emerging markets and do not expect too much from equities, at least in the short-term, a major European bank tells investors.

(February 8, 2012) — Investors should avoid equities and emerging markets in 2012 due to their poor earnings potential and downside risk, according to analysts on one of Deutsche Bank’s research desks. 

The team at the European bank looks at investments on a ‘cash return on capital invested’ (CROCI) basis and said 2012 would be another tough year for equity investors. A paper from the team published last month said: “Our core scenario is for a total return of around 5%, with dividends accounting for the bulk of this return, although the possibility of a second year of negative returns in a row cannot be ruled out.”

The paper said that while equities looked cheap at the moment, they were only cheap on long-term assumptions and there was ‘very little real earnings growth in equities around the world’. The bank’s analysts also said earnings downgrades would prevail over the year, pulling down world indexes and company valuations. There have already been significant warnings to the market. In January, technology giant Motorola announced an earnings warning in the US, which was followed by Australian bank Macquarie this week warning investors that its profits had been hit by the tumultuous market conditions.

Deutsche Bank said that even if none of the team’s negative predictions prevailed, the MSCI World index would end the year around 1206 points. This morning it opened at 1278. This opinion sits squarely against the views aired by BlackRock Chief Executive Larry Fink this week. Fink told Bloomberg that investors should allocate 100% of their portfolios to equities. In the view of Deutsche Bank’s CROCI team however, there is no underlying trend to pull equity markets out of the current slump.

“Trends play an important role in equity prices. Whilst they tend to be anchored to some real-life event, ultimately people can get carried away with them. They start to believe that they are secular and sustainable, where in reality they are often purely cyclical,” the team said. “These faddish trends have played an important role for stocks, sectors and markets. Think of TMT in the 1990s, the productivity boom of the 1990s, the BRICs growth of the past decade combined with a commodity boom and financial gearing. Our concern is that we see no obvious positive trends—in fact, we can only find negative ones, more likely to push multiples down rather than up, at least during 2012.”

Emerging markets, seen as many as the new growth engine for the world economy, offer no solace for investors, according to the paper.

It said that despite annual GDP increases for many of these nations sitting comfortably in double digits, emerging market equities showed a lack of real earnings growth. “Real earnings for emerging market Industrials have remained unchanged since 2007. Growth in inflation adjusted earnings per share for Brazil, Russia and India has not beaten the US since 2007. China appears to be leading the pack with phenomenal EPS growth, but we fear that this EPS growth is more illusory than real, as Chinese banks may be significantly underestimating their loan provisions.”

The paper offered one potential bright spot, however. It said the US was one area where investors might do well.

Deutsche Bank’s Francesco Curto, head of the CROCI desk, said: “We find the US to be the cheapest region in the world. This is a claim that may well raise a few eyebrows. But what ultimately matters for shareholders is free cash flow and the US is the cheapest region on FCF multiples, of which CROCI is a good proxy.

“Other regions may be cheaper looking at (accounting) earnings, but we believe that investors are becoming increasingly sceptical over the relevance of these nominal earnings.”

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