By Terry Ewing, investment director at Britannic Asset Management Conflicting trends in the econ...
By Terry Ewing, investment director at Britannic Asset Management
Conflicting trends in the economy and mixed news from the corporate sector have taken their toll on the equity market over the past month.
After rallying strongly from its July lows, the equity market has given up most of its gains and is now approaching July levels once more. The spectre of war has increased uncertainty.
The industrial sector has been a drag on both the economy and earnings growth for some time. The much hoped for recovery has failed to materialise and a number of major companies have posted profit warnings over recent weeks. This suggests there will be no meaningful recovery in industrial demand until next year.
The technology sector also continues to be a source of earnings disappointment. EDS, a consulting and outsourcing company, was considered relatively less exposed to weak IT spending trends but surprised investors by producing earnings less than a fifth of original forecasts.
Yet, despite this weakness in capital investment spending, economists have been increasing their economic growth estimates for Q4, in part a function of low inventory levels but also due to the continued resilience of the US consumer.
The consumer remains key to an economic rebound. Auto sales have hit record levels, surprising in strength and persistence, and the nesting trend, spending on the home rather than travel, remains a theme.
Although retail sales have shown signs of weakening, they will remain an area of relative strength as the impact of low interest rates and falling bond yields has resulted in a boom in mortgage refinancing. This is likely to release between $100bn and $200bn into the economy over Q4, acting as an equivalent to a tax cut.
What implications does this mixed newsflow have for the markets? Although not obvious from headlines, the absolute level of earnings has been improving steadily and more companies will exhibit earnings growth on a year-over-year basis this quarter.
However, it is the pace of the recovery that is disputed, as well as how much earnings are improving relative to expectations. Consumer stocks may surprise on the upside but uncertainty over the timing of capital investment could continue to put pressure on industrial stocks whose earnings estimates could be revised downwards. The weaker outlook for earnings and the shadow cast by the Iraqi situation suggests upside for the market will be limited for the rest of the year.
Earnings recovery has begun and insiders have stopped selling their own shares as they did earlier this year. Bonds have outperformed equities by a record amount over the past two-and-a- half years and equities at last appears to offer better value.
On prospective earnings and a price-to-cashflow basis, the market is more attractively valued than it has been for several years.
Growth coming out of past recessions has been a bumpy ride and this time will be no different. We expect there to be more potholes in the road ahead but by the time we see investors' concerns resolved, the equity market will already be significantly higher.
Growth forecasts for Q4 have been revised up.
Refinancing will release $100bn-$200bn.
Equities now looking like better value.
Threat of war has increased uncertainty.
Earnings hit by further disappointments.
Retail sales showing signs of weakening.
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