We believe the recent rally on Wall Street has further to go, supported by improved earnings and a f...
We believe the recent rally on Wall Street has further to go, supported by improved earnings and a further pick-up in underlying GDP over the third and fourth quarters. But investors should be wary of rich valuations as well as macro risks and in the context of global equities, Wall Street is unlikely to outperform.
Wall Street's late summer rally has been supported by stronger-than-expected second quarter profits growth, a slowing down of unemployment growth, a narrowing monthly trade deficit due to export growth and a substantial upward revision to second quarter GDP to + 3.1% (year-on-year) at the end of August, thanks largely to defence expenditure.
Cyclicals have been particularly strong, with poor quality stocks in particular benefiting from balance sheet repair. A mini bubble has grown in the IT sector over the past six months on indications of a pick-up in corporate capital spending.
So what of the future? The corporate and macro picture is encouraging. Business capital spending and hiring has been weighed down over the past few years by the excesses of the 1990s. The fallout from last year's accounting scandals increased the pressure on US businesses to retrench, creating a major obstacle to growth over the past 12 months. The good news, however, is these pressures have speeded up the adjustment process and helped to make US businesses healthier than a year or two ago. This is now paying off, in improved profitability and more robust balance sheets which have, in turn, contributed to stronger business spending. Business capital spending rose at an 8% annual rate in the second quarter, making significant contribution to the recent acceleration in real GDP growth. Strong consumer spending and rising capital goods orders and shipments are putting the economy on track, moreover, for perhaps 5% real GDP growth in the third quarter.
US businesses have little if any need for additional capacity. Manufacturers in particular are using less than three-quarters of their available capacity. But given continued downward pressure on pricing power, companies do have a pressing need to spend to make themselves more efficient, as the rising share of the US capital spending debate technology reflects.
What remains troubling is that business has not begun to step up hiring. However, even this seems likely to change soon. Corporate layoff announcements have declined over recent months to the lowest levels in almost three years, suggesting the pace of job losses should come down. In previous cycles, employment has lagged behind business capital spending by three to six months. We regard the recent increase in business capital spending - especially if it gains steam, which we expect it to do - as a positive omen for business hiring later this year and early 2004.
All this will be welcomed by investors. But will Wall Street see the benefit? The problem for us is investors seem to have already priced in the good news. Indeed, that current valuations imply an explosion of earnings growth, whereas we are looking for more gradual improvements. In addition to the well-known 'twin deficits' issue, two other macro factors are also worth bearing in mind.
Recent consumer growth in the face of limited income growth has depended not only on tax cuts but also on a slow rate in the restoration of savings. According to a recent report from Lombard Street Research, at 3.75% of personnel disposable income (PDI) household savings are some 4% less than the historical rate implied by current household wealth levels (measured as a ratio of PDI). A reversion to the mean, perhaps triggered by concerns over inadequate private pension provisions, could hit demand
The other rogue factor is the worsening Iraqi security situation, with the country potentially lurching towards civil war. This would hit the US economy via higher oil prices, bringing down stock market confidence, and increasing the fiscal deficit still further through higher military spending.
Globally, the balance of risks in the world economy appears to be shifting further in the direction of a renewed phase of global growth that may be stronger and more widespread than investors have been expecting.
If Europe gradually breaks out of its slump - which is looking increasingly likely - and Japan remains on its improved course, the world may be able to look forward to the first globally synchronised economic expansion in the last decade. Given the more attractive valuations of most overseas markets, Wall Street may underperform in such an environment.
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