Key is consumer confidence
Dogged by fears that weak indicators signal a hard landing for the US economy, equities are under pressure across the board. And strategists are concerned that corporate earnings news could get worse before it gets better.
But Federal Reserve chief Alan Greenspan has lightened the mood with his comments indicating the market may be suffering from little more than a dip in confidence and the effects of high oil prices and bad weather.
“The market is now very much focused on the state of the US economy,” says Lorenzo Codogno, senior economist at the Bank of America. The market is discounting negative or flat growth for the current quarter, and the next quarter is also expected to be roughly flat.
“But, at the same time, the market is discounting a rebound in the rest of the year,” he says. Bank of America’s data suggest that growth will be narrowly positive in the first quarter of this year, though the risks remain. “In the next three months the market will reconsider the state of the economy... if an economic rebound materialises, we will see higher share prices, but in the meantime we will start seeing new lows.”
Figures from the Philadelphia Federal Reserve released mid-February showed that consumer confidence in the US was collapsing. “My perception is that there might be some sort of vacuum between now and 2001, during which the optimism of the market will be tested,” says Codogno.
Consumer confidence is the key, says ABN Amro global economist Matthew Wickens. This appears to be Alan Greenspan’s main concern, though from a fundamental perspective he views the US economy more brightly.
In his half-yearly monetary policy report to the Senate Banking Committee, Greenspan said the risks of a serious economic downturn in the US are small, and that he was optimistic growth would rebound quickly from its steep decline of the last six months. Apart from buoying market sentiment, the central banker’s comments dashed hopes that US interest rates will be taken down much further than they already have.
The central bank dropped its key short-term interest rate by one percentage point in January in two separate moves to 5.5%, and is widely expected to lower it again when its open market committee meets on March 20.
Deutsche Asset Management’s economists are mildly bullish about the outlook for US bonds on a three-month horizon, but after that signs of stronger economic growth are expected to come through. This will lead to a general steepening of the yield curve in the second half of the year, one of the insititution’s economists said.
Deutsche’s chief global strategist Adam Seitchik has several reasons for optimism that later in the year equity prices should lift once more. “We think it’s going to be a bit of a bumpy road but that equities will be up in six months’ time,” he says.
On the valuation side, equities have become cheaper relative to bonds and cash in the past 12 months, he says. Over that period, 10-year bond yields have fallen 1.8% while yields on two-year paper have dropped 1.4%. Secondly, interest rates and tax rates are seen as on their way down, and both of these situations have been associated with rising equities prices in the past.
A third factor supporting the view that equities will recover is that the rate of US economic growth will probably bottom sometime in the first half and rise in the second.
“But it could be bumpy because whether that happens in the first quarter, second quarter or is delayed into the second half is a very difficult call to make,” says Seitchik.
Wickens says ABN Amro’s strategies are overweight in equities now, but within the equities portfolios the US position is neutral. “In the short term we think there is more pain to come,” he says. “We’re looking at a dog-leg forecast with things worse in the few months ahead,” but bouncing back after that.
Economic data have recently shown that there has been a sharp increase in unit labour costs in the US. But because of stiff competition, these costs are unlikely to be passed on to consumers, which means the wage rises will feed through into lower corporate profits.
The rush of fourth-quarter earnings figures that hit the market in February showed profits were down significantly for many companies, but downgrades were mainly confined to the technology, media and telecommunications sectors. However, the latest earnings figures have been particularly worrying showing that other sectors are affected by the malaise.
The shares of ConAgra, the second-biggest food maker in the US, lost a fifth of their value in the aftermath of reporting its fiscal third-quarter earnings estimate had halved. “If it starts to spread to other areas of the economy, then it is a worry,” says Wickens.
Merrill Lynch’s equity strategists comment in the bank’s market analysis that healthcare and financial services relative valuations appear rich given their growth prospects. Technology multiples, on the other hand, seem to have improved a lot.
Historically, technology and consumer cyclicals, says Merrill Lynch, have produced the most reliable returns in soft-landing markets.
Consumer cyclicals such as retailers and car stocks have started to pick up lately from depressed levels, on the back of the view that the economy will recover in the second half. If that stronger growth does come through, these stocks could be among the main beneficiaries of the change, says Seitchik.
Overall this year, Wickens sees the old economy stocks gaining, with the S&P 500 likely to end the year higher, but the technology-laden Nasdaq has further to fall, he predicts.