Tax on dividends has been cut by more than half but the boost in yields is only one patch of light in an otherwise gloomy investment environment in the US
Wall Street leads the way for other markets to follow. That is the conventional view. US equity indices touched their low point on 9 October 2002, some five months in advance of their European counterparts and over six months before the Japanese stock market bottomed at the end of April.
In a sense, therefore, other markets have lagged, rather than tracked the US. This directly mirrors the advanced stage that the US occupies in the economic cycle.
The US economy has been subjected to enormous stimulation on a broad front, so it is hardly surprising that recovery can be detected there, whereas the position in Europe is still deteriorating.
The Federal Reserve's action in cutting interest rates from more than 6% to 1%, the Bush tax cuts, mainly in the form of low taxes on dividends, amounting to $350bn and the weakness of the dollar have all contributed to what one commentator describes as 'an unprecedented campaign of using the policy levers in unison in such a powerful way'.
If this cannot do the trick, then nothing will. Alan Greenspan has even flagged the possible risk of deflation and outlined a further range of measures (in addition to interest rates) to deal with its occurrence. The authorities have thought of everything to stimulate the economy and to ensure that the incumbent is well placed in his campaign for re-election in November 2004.
Yet the economic outcome has been mixed, rather than compelling. Consumer spending and the housing market have remained solid, recovering from a wobble just before the war with Iraq. There are signs of progress in both manufacturing and service areas, but with overcapacity still in evidence, capital expenditure will be slow to revive. That is a potential drawback, especially for areas, like technology, which are currently discounting such a trend.
Another worrying sign for the economy is that the labour market remains under pressure, with unemployment at 6.4% and apparently set to rise further.
There is a further potential negative from the bond market. Treasury bond yields, which set the level of mortgage loans, have hardened considerably in recent weeks, with some commentators flagging the end of the bull run for fixed interest stocks.
That would be an unwelcome development for the Federal Reserve, which is anxious to maintain the momentum for recovery, by signalling that it will hold short term interest rates at low levels until normal growth (3% or more) is achieved.
Despite this, many observers are pointing to higher bond yields, a potential negative for mortgage refinancing activity, which has acted as a key driver of consumer spending.
The S&P 500 and Dow Composite indices have risen by around 25% since last October, amid a marked revival in investor confidence, especially since the war with Iraq. The turn in the equity market exactly coincided with the decisive narrowing of corporate bond yield spreads, especially those of sub-investment grade issues. This trend was sustained throughout the difficult early months of 2003, which depressed sentiment especially towards non-US equities. Driven by a growing income shortage and an adverse supply/ demand relationship, equity investors should closely watch the corporate bond market for signals it is giving about risk-aversion and the health of company finances.
Mainstream equity indices have been significantly outpaced by those representing technology/biotech, mid-cap and smaller companies. These have been the star turns. Hence the Wilshire 5000 (the most broadly-based US equity index) has gained 30% since the October low, while the S&P mid-cap and smallcap indices have risen 32% and 35% respectively over the period. However, pride of place is occupied by the technology-dominated Nasdaq index, which has recovery by 54% from its low point.
These gains reflect both a reaction from a previously oversold position and a recovery in investor faith in the ability of these high-beta stocks to benefit most from an improvement in the economic and business environment.
In our view mainline technology stocks (eg Cisco, Intel, Microsoft) now appear fully valued and are discounting a revival in spending in the area which is both earlier and much stronger than we anticipate. Likewise, mid and small-caps have been driven by their more limited liquidity and by the relative abundance of modestly valued stocks in their ranks. They may be vulnerable if economic growth fails to come up to expectations, although selective buyers can still find bargains if they make the effort.
Given the relatively full valuation of US equities (a forward price earnings ratio of around 17 and yield of 1.6%), investors are very dependent on economic and corporate newsflow continuing to at least match expectations.
First quarter earnings were generally satisfactory because of management vigour in cutting operating costs. Revenue growth, which is dependent on pricing power, gains in market share as well as the improving macro-economic environment is proving far more elusive.
The current (second quarter) company reporting season, lasting from mid-July through to early August, is being closely scrutinised, with particular emphasis on the tone of chief executives' comments on the near-term business outlook. Any ambivalence or disappointment over the business outlook and the momentum of the economic recovery may see investor confidence slip into reverse and hedge fund managers open fresh short positions.
After all, it was the lack of confirmation of recovery hopes in 2002 which turned back earlier rallies.
We remain cautious on the US equity market, relative, for example, to those in Asia, which are both cheaper and offer more positive company earnings profiles. Buyers need to be more selective and to be prepared for the re-emergence of higher levels of volatility.
However, one feature that inspires us is the apparent re-emergence of investor interest in dividends and signs of a real change in company attitudes towards them. This is being driven by the recent reduction in taxes on dividends for taxpaying shareholders from 38% to 15%, which brings the rate in line with the charge on capital gains. The overall market yield of 1.6% is low by world standards, so there is much catching-up to be done.
But there are signs of a significant reduction in the level of dividend cover, together with evidence that cash rich companies, which have hitherto distributed surplus cash by means of share buybacks, might be shifting their ground.
We believe that prominent recent examples of substantial increases (Bank of America and Goldman Sachs) and of maiden payments (Microsoft) point the way forward. From now on, healthy dividend increases will be taken by the market as indications of confidence in the future.
Government measures to boost the economy have been more significant than in other economies.
Economic outcome has been mixed with rising unemployment and overcapacity still evident.
High beta stocks in biotech and technology are now fully valued and vulnerable to a dip in economic growth.
Asian equity markets are cheaper and offer more positive company earnings profile.
Reduction of tax burden is driving higher dividends.
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