Fund manager's comment/Nigel Holland
After several years of challenging valuations within the equity markets against a backdrop of good fundamentals, investors are now faced with uncertainty over the economic outlook, with news on the margin continuing to deteriorate.
The cutback in technology-related capital spending continues to depress the profits cycle. In addition to the likelihood of further bad news from technology in the second quarter profits season, the longer-term expected growth rates still remain optimistically high, as do valuations in the sector generally.
Rising unemployment and a low savings rate suggest consumer spending is likely to remain sluggish at best. A significant tax cut and the lagged effect of interest rate cuts to date should contribute to growth in the second half of the year, in addition to less of a drag from the inventory cycle. A vigorous profits recovery is unlikely however, as labour compensation trends deteriorate and productivity gains abate in a slower nominal GDP world.
Despite the worsening economic and financial landscape over the past sixteen months, foreign capital flows have continued to finance the current account deficit, supporting the dollar and fixed income markets. A continuation of this trend remains a prerequisite of a positive outcome for investors in general.
The current earnings yield/bond yield relationship suggests fair value, and further declines in interest rates are anticipated, in addition to the aggressive cuts year to date. Liquidity growth, as measured by M3, suggests a positive trend for credit conditions and progress in the equity market.
While the current disappointing trend of the corporate profit cycle continues to be the main impediment to a big upward move in the equity market, valuation and monetary factors are supportive and likely to prevent a big fall in the market.
While technology shares are likely to continue to suffer profit taking during the reporting season, we anticipate relative outperformance from Microsoft, IBM and semiconductor stocks when the inventory position is improving, and continued weakness from the telecommunications capital spending related area.
Within financials, insurance stocks are expected to do well as the premium cycle continues to improve, but we remain cautious about the impact of the credit cycle on the banking sector. Within the consumer cyclical area, an already strong housing and auto cycle to date suggest a more muted response going forward from further interest rate cuts.
The more defensive consumer staples areas are likely to provide a safe haven in the next few months with the emphasis on pharmaceuticals, as leading consumer product companies, such as Proctor and Gamble and Gillette, continue to disappoint investors.
Lagged effect of rate cuts to come.
Positive trend for credit conditions.
Finance for current account deficit.
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