Although 2002 was certainly a challenging year for US equity investors, it could have been worse....
Although 2002 was certainly a challenging year for US equity investors, it could have been worse. The Federal Reserve's policy of uncompromising expansionary monetary policy appears to have had the desired effect.
Interest rates currently stand at a 44-year low and money supply is robust. This has encouraged consumers to carry on spending, thereby underpinning the economy and contributing to impressive third- quarter GDP growth of 4.0% on an annualised basis.
Meanwhile, companies have boosted profits by focusing on cost cutting to stabilise profit margins, while at the same time repairing balance sheets from years of overly optimistic investment.
Without these positive factors, stock market returns could have been even worse than the 15% losses experienced over the last twelve months. The biggest risk now lies in the possibility of renewed recession as a result of excessive caution within the corporate sector.
Capital spending fell sharply in 2002, with gross investment in equipment and software declining to a level only modestly above the rate of depreciation. In other words, the key focus has become one of survival rather than expansion and the prudence that helped companies repair their balance sheets could now threaten economic recovery. Fortunately, George Bush appears likely to heed the words of his predecessor, Bill Clinton, that 'it's the economy, stupid'. After all, George Bush Snr was ousted largely as a result of the faltering economy despite a successful military campaign in Iraq and his son will not want to see history repeating itself.
This makes sense of the recent reshuffle that saw Paul O'Neill and Larry Lindsey deposed as Treasury Secretary and Economic Adviser respectively. Their replacements, John W. Snow and Stephen Friedman are likely to fall in with Bush's stimulatory tax-cutting policies.
This continuation of stimulatory measures has implications for US equity portfolio managers. Over the last year a defensive weighting has yielded the best returns given the challenging environment. The question now is whether economically sensitive stocks will continue to respond to monetary and fiscal stimuli?
If an economic recovery can be sustained, cyclical sectors, such as industrials, resources and materials can be expected to do well and there could be scope for the beleaguered technology sector to pick up. Although technology stocks are still not cheap, profits in the sector are now showing signs of stabilising after two years of downgrades and it is possible that forecasts could now have become overly pessimistic.
Profits are showing signs of improvement in other sectors as well. The third quarter of 2002 saw the first year-on-year rise in company earnings for two years. If earnings can begin to exceed expectations, this could also generate positive momentum.
While it is probably still too early to recommend a wholesale move into economically sensitive stocks, if the US can continue to put corporate malpractice behind it, by the time of the election in 2004 the economic picture could be a lot rosier.
Interest rate cuts will help economy.
Further monetary and fiscal stimuli likely.
Profits showing signs of improvement.
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