On the whole, equities are not that cheap in absolute terms. However, the earnings yield on global equities is still considerably more attractive relative to the yield on a basket of sovereign bonds (1.1%).

Equity valuation is always conditional on earnings or profits. Our fear is that the correction in global equities reflects a genuine deterioration in the profit cycle. While the weakness at a global aggregate level probably reflects the cyclical deterioration in manufacturing and trade, it is possible that there are also structural conditions weighing on profits in select markets.

The ongoing weakness in global manufacturing, trade, Asian exports, and commodity and producer prices is evidence of the trend of underperformance in emerging market. While this condition is well appreciated, our fear is that it is legitimate and not fully played out nor priced into all related assets.

The good news is that growth in the domestic US economy and Europe remains firm. The US unemployment rate is near full employment (5.1%) and housing activity is contributing to growth. In Europe, loan growth is expanding for the first time in ten years.

While high yield spreads offer above average levels of spread (or risk) compensation, a genuine profit recession would be challenging for the sector’s fundamentals. A rise in default rates is also plausible next year.

Private sector credit has increased since the last crisis and might contribute to a challenging phase for emerging markets next year if US dollar strength and/or commodity price weakness persists.