The key factor for investing in markets is the outlook for the US economy. After 10 years as the eng...
The key factor for investing in markets is the outlook for the US economy. After 10 years as the engine to robust economic growth, the wheels appear to be falling off.
At the same time, spending in technology stalled and the mainstays of the long bull market, such as Cisco and Dell, downgraded their expectations. This had a dramatic effect on their share prices as they were trading on high multiples.
In response to the deteriorating economic background, the Federal Reserve has responded by cutting interest rates by 1% in January, with further cuts expected.
Europe has not yet suffered to the same degree but will see some wash over. In the UK, interest rates have already fallen once, while the European Central Bank is more concerned by small signs of inflation, mainly caused by the weakness of the euro and the oil price, than the dangers of a slowdown. There is a danger that they will remain behind the curve and cause an unnecessary slowdown.
Government bonds have performed strongly as interest rates have fallen and investors flee to their safe haven.
This has provided a helpful background to traditional income shares, which, following their dreadful performance until March last year, have seen a strong recovery. This has moved most shares up from the bargain basement territory to which they had fallen.
The key feature of the long economic expansion has been the lack of inflation. In the past eighteen months, there was pressure on input prices to industry led by large increases in oil prices and some wage pressure as unemployment fell. Despite this pressure, there has been no increase in the rate of rise output prices, which are now running at below 2%. This estimates the pricing pressure that is facing most companies.
As the economy slows, this pressure is likely to increase. Most income shares are not in the position to generate significant volume growth. This means that profits will be under pressure and the prospects for long-term dividend growth is poor.
Under this scenario, pressure on share prices will resume as investors will be able to obtain superior income returns from many corporate bonds with similar risk characteristics.
Many companies will react to this pressure by acquiring competitors so that they can eliminate duplicate costs and achieve benefits of scale. This will mean continued corporate activity in the bottom end of the market where many institutions have abandoned investment.
In an era of low inflation, investors will return to genuine growth companies. At present, we are going through a period of discovering that many growth companies do not have the ability to grow through the economic cycle. However, many genuine growth companies are also being pulled back and are providing a good buying opportunity.
George Luckraft is manager of the ABN Amro Equity Income Fund
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