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Good prognosis for US recovery

The massive monetary stimulus of 2001 and possibly another fiscal boost in 2002 should be enough to ensure the US sees an economic recovery in the second half of this year. The greater question concerns whether an economic rebound is already discounted in equity valuations.

A great deal of bad news was absorbed by the US equity market in 2001 – an economic downturn, the tragedy of September 11 and high-profile corporate failure in the shape of Enron.

We expect better returns this year but some caution is still merited. From the lows of September 21, the main equity indices have risen by just over 15 per cent, boosted by US military success and reflecting greater optimism on the economy. We believe this optimism is warranted.

Fourth-quarter GDP growth edged up surprisingly by 0.2 per cent and showed continued gains in productivity. Record levels of inventory liquidation in the same quarter will mean that the economy will be more sensitive to an uptick in end demand.

Consumer confidence improved last month, with the expectations component of this economic measure showing most gains. The labour market, which is typically a lagging indicator of economic recovery, also appears to be stabilising, with unemployment having fallen slightly in January.

US consumers have traditionally been very responsive to interest rate cuts and, with rates now 4.5 per cent lower than at the beginning of 2001, this bodes well for consumer spending going forward.

Consumers have shown remarkable strength throughout the economic downturn and, while concerns over rising consumer debt and bankruptcies are real, they appear overblown. Despite two years of falling stock prices, asset values have kept pace with debt as real estate prices have remained firm. Low levels of interest rates and mortgage refinancing have ensured that debt service levels have remained in check.

Historically, periods of economic recovery have been marked by a release of pent-up demand from consumers. However, we believe this will be more subdued as consumers have continued to spend throughout the recent downturn. Greater leverage to recovery is likely to come from the industrial sectors of the economy which have suffered most in the last 18 months. Basic materials and capital goods sectors will benefit most strongly although many of these stocks have already risen in anticipation of recovery.

We believe consolidation will be an investment theme across all sectors as comp-anies strive to further improve productivity and reduce costs.

In particular, healthcare – with a focus on mid-cap stocks – continues to offer diverse opportunities and will continue to benefit from favourable demographics. Corporate IT spending should recover with the economy although the overhang from pre-millennium overspending will dampen this somewhat. We see the greatest opportunity in those IT companies which benefit from a return to price stability in their markets.

Investors in the US equity market are still digesting the fallout from the collapse of energy giant Enron. This will continue to weigh on sentiment as investors scrutinise the transparency of corporate balance sheets and apportion valuations accordingly.

While we remain convinced of the prospects for an economic recovery, our outlook for the market is tempered somewhat by high earnings expectations. Expectations in the second half of the year call for a recovery to peak earnings&#39 levels. However, some recovery in top-line sales growth coupled with cost cutting, reduced capital investment, lower interest charges and easier comparisons should ensure a return to positive year-on-year earnings growth early in the year, which will ultimately drive the market higher.


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