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Geography lesson

Asset allocation decisions for investors are implicitly and explicitly influenced by their attitude to the US. Wall Street is the biggest market, the US is the biggest economy and, courtesy of a high spending consumer, has been the dominant source of growth in economic activity – the catalyst of the recovery.

In the upswing, earnings growth has been geared to the economy as a whole. Cost reductions have been important, too. It is not just the consumer who has benefited from the increased use of China as a manufacturing base. The effect of these factors in combination has been dramatic. Against a long-term average of 6 per cent, corporate margins are now at 9 per cent. This combination of an exceptionally supportive background and a mature and perhaps extended trend might be a reason for caution.

However, this is not the stance of the stock and sector analysts on Wall Street. Firm believers that “the trend is your friend”, the group has extrapolated the past into the future. Earnings forecasts for 2007 and beyond suggest growth of 12. The question is how realistic is this scenario?

The answer seems to be that it is excessively optimistic. Forecasts for the overall level of growth within the economy are under pressure from a stalling housing sector. We know that in recent years the increase in consumer activity has been funded by lower mortgage financing costs and equity withdrawal. As these are both difficult in current conditions, we must expect a much lower contribution from high-street spending. The decision by the Federal Reserve to pause the programme of interest rate increases shows that the US authorities are aware that there are now threats to growth.

A reduced pace of economic expansion, though, is far from the only threat to earnings. Capacity utilisation rates are up at 87 per cent, the highest they have been for eight years, and with the labour compensation share of GDP at a 20-year low, wage claims are set to rise to reflect corporate profitability rather than fear of job security.

Despite the optimism of the analysts, it seems clear that earnings estimates are too high and need to be reworked to reflect the future and not the past. What then happens to Wall Street in an obvious concern. But this is not simply a US question because implicit in the bull market is an expectation of more growth and more earnings in the world economy. A test for the multi manager is not spotting the challenge, it is working out where the impact will be greatest. Geographical selection is likely to be key.

John Kelly is head of client investment at Abbey


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