Is it possible that global markets are on the verge of an upturn?
United States: Overweight
The US rocketed ahead during the third quarter, boosted by increased levels of business investment and consumer spending, which jumped by 3.5% year on year during the three months to September.
More importantly, capital expenditure has continued to increase. During Q3, business investment was up 6.5% year on year, helped by greater spending on equipment and computer software, and the consumer's demand for US products.
US share prices are trading around fair value, assuming profits are upgraded 13% in 2004 and 6% year after. This implies an annual return of 8% in the long term, but we believe there is potential for higher returns if profit share continues to rise, as we feel it will.
On the cautious side, there are still considerable risks remaining. Almost three million jobs have been lost since 2001. While this helps companies increase margins, new jobs need to be created if the economic recovery is to continue long term. The continued risks explain the Federal Reserve's decision in October to keep interest rates onhold at 1%.
The UK economy looks most likely to deliver earnings upgrades in the next 18 months on a top-down basis.
There is scope for upgrades to next year's profits and our smaller company fund managers feel that analysts are still conservative on a bottom-up basis.
We are assuming 15% earnings growth next year and 5% the year after. This growth should take place even though the Bank of England's interest rate policy has now switched to a tightening bias.
There is real anticipation about how far interest rates will rise. Bond markets indicate that rates could move up to 5% but we believe they will peak at 4%.
With the valuation gap between small and larger companies disappearing, some fund managers have reduced their small-cap positions. We do believe, however, that smaller companies still offer very good value in an environment where larger companies have lots of cash and can make acquisitions.
We remain sceptical about the ability of European companies to grow profit share in the next 18 months.
The focus on Europe remains on companies cutting costs, as there is little sign of an increase in consumer borrowing to fuel spending. Reform in labour markets and pensions remain the areas most likely to surprise, although little is currently expected from the main protagonists, France, Germany and Italy.
Our focus in continental Europe remains on smaller companies, which can demonstrate growth at a reasonable price, or are restructuring.
Jonathan Asante, chief economist, Framlington
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