In case anyone hadn"t noticed, the US dollar has been a little weak of late. More surprising is that...
In case anyone hadn"t noticed, the US dollar has been a little weak of late. More surprising is that, despite this, the five year annualised return in euros of the S&P 500 is ahead of the FTSE 100, the CAC40 in France, and the DAX in Germany.
This is an encouraging statistic, but there is no question that to invest in the US market is to take on a fair degree of 'excess baggage".
Firstly, getting an $11trn economy back on track doesn"t come cheap. Despite Greenspan"s warnings not to blow it, fiscal initiatives combined with increased defence spending have seen the Federal budget fall from a $300bn surplus to a whopping $400bn deficit in only three years. Meanwhile, the resulting weak dollar is helping to propel a current account deficit which now stands at over 5% of GDP. The volume of imports is almost 50% larger than the volume of exports, so the net export deficit will most likely continue to widen. Government spending will also grow at a moderate pace as state and local budget problems play against the continued rapid expansion in federal defence spending.
Therefore the ongoing need for the US to attract foreign fund inflows to help ease the deficit will remain strong, and how foreigners view their return on investment for US assets will be critical in determining the flow of capital.
Fortunately the Bank of Japan has been extremely accommodating, buying a record $67bn in the foreign exchange markets in January. However, with the yen not really weakening and continued evidence of a Japanese recovery, the authorities might well question the wisdom of holding the currency down - especially if it means buying $67bn per month.
Secondly, the issue of job growth: or rather the perceived lack of it. In the last cycle we were 11 months into the recovery before we saw job growth begin; this time it has taken 21 months to see signs of life.
However, the current pace of job growth, combined with rising productivity, means that there is limited pressure on inflation. US companies are manufacturing more product with less human capital: unit labour costs are falling by an amazing 2.3% year on year. It therefore seems likely that the Fed will keep rates on hold at least until September and quite possibly beyond.
Good news is also to be found in economic growth and corporate profits, as the US continues to mop up its excess capacity and close the much talked of output gap.
The latest fillip to the beleaguered US consumer is the $60bn boost to household cashflow during tax-refund season, money that we can expect to see put to work in the consumer sector, amounting to at least 2% of GDP. This could see consumer spending rise to 5% in the second quarter before falling to a more sustainable 3% in the second half of the year.
On the industrial side, the ISM Manufacturing composite is at its highest since 1983, and is consistent with 5%+ GDP growth. Strong corporate profit growth and new budgets reflecting the improved business conditions should spur capital spending to 15% growth in 2004. This will receive an added boost from the expiration of investment incentives that will likely cause some activity to be pulled forward from early 2005. Inventory re-building will also help to provide some longevity to the upturn in growth, as manufacturing and trade inventory as a percentage of sales hit a record low in November.
With corporate profits growing rapidly, output expanding and capital spending improving, it appears as if the nascent labour market recovery should strengthen over time.
Furthermore, over the past year the trailing P/E on the US market is roughly unchanged. Returns have been principally driven by robust earnings growth - a result of strong productivity gains enabling companies to drive down costs and expand margins in an environment where there is little pricing power. This is reflected in the rise of the share of profits as a percentage of GDP, which has soared to the highest level since the late 1990s.
The P/E ratio of the S&P 500 on 2004 operating earnings is 17.1, still high, but approaching its long-run average and providing some attraction to those seeking close to 20% earnings growth in a developed market.
A strong economy, low inflation and low interest rates are the sweet spot for equities, and it is likely that, with the Fed on hold for now, the market can continue to rise.
Finally, within the market itself, the dissipation of extremes at the time of the tech bubble has seen valuation spreads between the highest and lowest valued companies collapse from 50% above average at their peak in October 2002, to 25% below the norm today. With anomalies not so obviously apparent to the average investor, an investment strategy based on detailed research of individual companies, such as that carried out by the US Research Team at Schroders, will be key to generating excess returns.
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