Market Review: So far so good for the US – but will it continue?

The United States economy has moved from a recovery to an expansionary phase with strong economic data being produced in virtually all areas. Yet another example occurred over night with the Institute for Supply Management stating its index of US manufacturing activity accelerated in November and was the strongest in 20 years.

The missing piece of the economic recovery jigsaw was job creation but this is now occurring with three straight months of employment payroll growth and US unemployment falling to 6.0% in November.

There is currently some slow down in the extremely high consumer spending levels of the September quarter, which had led to an annualised GDP growth rate of over 8%. However, the December quarter will also be strong as companies are rebuilding low inventory levels. Previously they had kept stocks low, uncertain whether the US recovery was real. However, the extent of demand for goods has caught many manufacturers by surprise and they are playing "catch up", lifting production levels significantly. Companies are also increasing capital expenditure to raise production.

After the tech "bubble" (which occurred through overly optimistic earnings growth expectations) the US sharemarket correctly predicted this economic recovery, rising well before the actual recovery commenced.

But what will happen to the US equity market from here?

In the most simplistic sense equity market direction comes down to interest rates and corporate earnings growth and each of these are looked at in turn.

Interest rates. As we all know the US Federal Reserve ("the Fed") has had a policy of very low interest rates in order to stimulate the US economy. The interesting issue now is: when will they tighten? Any rise in rates is usually a negative for equity markets for three main reasons:

1) higher interest rates prove a more attractive home for the marginal investment dollar – so instead of going into equities, cash and bond yields become more attractive

2) the discount rate used to value future company cash flows goes up, thereby bringing down company valuations

3) rising rates slow down an economy and therefore aggregate corporate earnings as well. The high current level of household debt in most countries and buoyant property prices could both accentuate any slow down from interest rate rises.

All the market signals sent out by the Fed to date are that they will hold off on rate rises for as long as possible in order to ensure the recovery is sustained. However, in doing so the imbalances inherent within the US economy will continue to mount thereby potentially exacerbating the potential economic and market adjustment when it does. Thus, it may be in the Fed's interest to "massage" rates gradually upwards to ensure no repeat of previous equity (or residential property) market "crashes".

Either way the direction of interest rates will be upwards in the US, and in most developed countries, through 2004 – expected to be a negative for sharemarkets.

Corporate Earnings growth. As correctly picked by analysts and the markets US companies are currently experiencing a profit boom. This is from a combination of higher revenues and lower costs – the former due to strong consumer spending, the latter due to significant productivity gains. However, the almost perfect conditions of the second half of 2003 are unlikely to be repeated in 2004. Thus, the issue is how much profit growth falls from the current unsustainable levels.

The current pause in the US equity market suggests investors are assessing this key issue and are uncertain about the earnings outlook. The good news is that it is not just the US in recovery mode with Japan starting to grow and even some positive signs from Europe – particularly from the UK. Combine this with a weaker US dollar and the equity market, while right to pause, may at least consolidate around these levels through 2004. This is as long as the interest rate increase mentioned above, and the US dollar decrease, is gradual and there are no external or unexpected shocks.

In terms of the market numbers for November the New Zealand equity market continued to surge while unhedged offshore equities struggled. The NZSX50 Index was up 1.7% for the month and is up over 20% for the past year. Before any currency effects overseas equity markets were mixed with the NASDAQ continuing its rise (up 1.5%) but Japan struggled, being down 4.4%, with much of that being post-election.

On the bond side, in New Zealand the CSFB Government Bond Index was up 0.1% for the month and the past three months. Global bonds did significantly better, with the Lehman Index up 0.5% for the month and 2.0% for the quarter.

On the currency side US dollar weakness continued with the Kiwi dollar appreciating 4.0% against it for the month and a whopping 28% for the past twelve months!

This gradual US dollar weakness is one reason why the downside risk to the US (and therefore global) sharemarket has lowered over the past few months, especially when combined with the renewed and sustained strength of the US economy.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

Anthony Quirk is the managing director of Guardian Trust Funds Management.

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