The US markets have recently experienced a considerable degree of volatility, with the S&P 500 index...
The US markets have recently experienced a considerable degree of volatility, with the S&P 500 index experiencing an 8.1% intra-month swing in January. Investors viewed mixed economic data points, headlines and corporate news and sought to gain greater clarity on the health of the US economy.
A key theme that has emerged to explain the current economic malaise and market volatility has been the negative impact of a possible conflict in the Gulf.
While a resolution of the current Iraq crisis would initially restore consumer and business sentiment, it is unlikely to lead to a strong cyclical recovery in capital expenditure. This is because the US economy is undergoing a rather painful, but necessary rehabilitation process to work through the investment- led excesses of the late 1990s. This is requiring companies to focus on restoring the health of balance sheets rather than initiating new projects.
Research conducted by Merrill Lynch demonstrates that while corporations are focusing on cash generation and debt reduction, '45% of investment grade US corporate bond paper is currently BBB rated ' the highest percentage since 1998. When so much debt is one notch above 'junk', corporations have little choice but to use their cashflow to pay back debt rather than increase capital expenditure'.
The present low inflationary environment also poses a challenge for the manufacturing and industrial sector as it makes it increasingly difficult to pass on to customers the above inflation increase in raw material and energy prices.
The CRB Index, which measures a broad basket of commodity good prices, has increased by 30% over the last year. Pressure at the gross margin line is also being felt at the operating line as companies contend with a medical cost trend running at 10%-12% per annum. This has meant that while annual salary rises have been accommodative, total employment costs which include wages, healthcare and pension costs have increased above the rate of inflation.
While such headwinds may slow margin expansion, the economy appears to have stabilised, partly as a result of the considerable monetary and fiscal support it has received. This stabilisation is illustrated by the recent unemployment data, which shows that initial claims are declining below the 400,000 level, and the unemployment rate is hovering around 6%.
Thus while fewer people are being made redundant, as seen by the initial claims' data, there is little sign of new jobs being created. It is from such a viewpoint combined with our stock specific fundamental analysis that leads us to believe that earnings growth for the S&P 500 will be in the mid to high single digit range over the course of this year.
Our optimism is tempered, however, by what we believe are unrealistic and aggressive earnings expectations embedded within current consensus forecasts, particularly for the second half of this year. The 'back- end loading' of consensus forecasts means that the likelihood of negative earnings revisions in a number of areas is likely to persist.
Resolution to Iraq issue would help confidence.
Capacity utilisation at ten-year low.
Accommodative fiscal and monetary policy.
Paul Bruns and Elaine Parkes
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