While there are signs that the US economy has bottomed out and economic recovery is round the corner, investors still need to be cautious as they decide how much of a rebound there will actually be
An economic recovery for the US should be ensured in the second half of 2002, thanks to the massive monetary stimulus of 2001 and the potential for another fiscal boost this year.
Some caution is still required as investors wrestle with valuations and try to decide how much of an economic rebound has already been discounted by the market. But although the equity market remains in negative territory year to date, we expect better returns going forward.
A great deal of bad news was absorbed by the US equity market in 2001 ' the events of 11 September, an economic downturn and high-profile corporate failure in the shape of Enron. From the lows set on 21 September through to the end of December, the main equity indices rose just over 15%, driven in part by military success but also by optimism about the economy. We believe that this optimism was and is warranted. Here are some of the factors that contribute to this view:
l Fourth-quarter GDP growth surprisingly edged up 0.2% and showed continued gains in productivity.
l Record levels of inventory liquidation in the fourth quarter will mean that going forward, the economy will be more sensitive to an uptick in end demand.
l Consumer confidence has also improved and the labour market appears to be stabilising.
l Housing starts in January reached record levels and the nation's largest home improvement retailer Home Depot reported earnings of $3bn, up over 50% on last year.
The consumer has shown remarkable strength throughout the economic downturn and while concerns over rising consumer debt and bankruptcies are real, they appear overblown. Despite two years of falling stock prices, asset values have kept apace with debt as the real estate prices have remained firm. The low level of interest rates and mortgage refinancing has ensured that debt service levels have remained in check. These factors are undoubtedly why the consumer discretionary sector was the best performing in the S&P500 last year ' much of the rebound in consumer spending has already been reflected in valuations. With the consumer having spent throughout the downturn, the release of pent-up demand that historically marks periods of economic recovery will be more subdued in this cycle.
The technology sector would undoubtedly benefit from a recovering economy, but unlike the industrial and materials sectors it still has to contend with prior years of over-investment. Technology sector stocks performed very strongly in the fourth quarter of 2001, despite deterioration in the health of its customer base. In 2000, 40% of IT spending came from the telecommunications sector and from the financial sector.
The telecom sector is distressed and has been likened to the banks in the early 1990s. Communications equipment spending is likely to be down in excess of 35% this year.
Recovery in these end markets will take longer than the recovery in the economy as a whole and accordingly, IT spending overall is likely to lag economic growth. However, there will be some pockets of strength, such as storage and security, which have gained share of IT budgets. The technology companies that have most aggressively cut costs, gained market share and have deep cash pockets offer the greatest opportunity.
Economic recovery will not be the sole determinant of US equity market returns in 2002 however. The political landscape will remain influential with healthcare and insurance particularly vulnerable in this election year. Perhaps more ominous is the potential for further military action in the Middle East, which could delay economic recovery but also impact upon the valuations that investors award.
Investors are still digesting the fallout from the collapse of energy giant Enron. Focus on the reporting of earnings will be as important as the accounting for earnings. Transparency of data has traditionally separated the US stock market from many other markets around the world.
The confusion over the use of pro-forma (unaudited) rather than GAAP (generally accepted accounting principles) argues for much lower valuations than currently exists in order to compensate investors for greater risk of less conservative accounting standards. Quality as well as quantity of earnings will be crucial.
On the quantity of earnings growth, we are concerned that estimates currently reflect an expectation of a return to peak levels of earnings by the third quarter of 2002. We believe that this will be stretching, but nevertheless remain optimistic of a return to double-digit earnings growth in the latter part of 2002.
Overall, we expect the equity market to end 2002 higher, driven by back-end loaded earnings in 2002 and the promise of more consistent growth in 2003. Volatility and sector rotation will remain key features as investors confront political and accounting pitfalls.
We expect that as economic growth accelerates, the consumer related sectors that performed so well last year will progressively underperform, with better gains coming from industrials and select technology stocks.
US economic recovery looks certain for second half, thanks to huge monetary stimulus of 2001.
While tech sector will benefit from recovering economy, it still has to deal with previous overinvestment.
Potential for further military action in Middle East remains in the background.
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