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On balance

Despite the economy slowing in the first quarter, the US markets still represent good value, especially as GDP is expected to remain stable in the second half of the year and into 2008. It is worth bearing in mind that the US may not be the fastest-growing economy but it is still the biggest and it benefits from the rapid growth seen internationally.

Two metrics that are useful as a broad-based gauge of the state of the economy are the earnings’ growth figures and the level of unemployment, currently at 4.7 per cent. Unemployment is expected to increase slightly but it is still at multi-year lows and a long way from its last peak in mid-2003.

Corporate balance sheets are looking very healthy, with high levels of cash. This has come on the back of a run of 14 quarters of double-digit earnings’ growth. In 2006, earnings grew by 16.6 per cent while the S&P rose by 13.6 per cent. This has left the indices priced at very reasonable levels.

With almost all third-quarter earnings’ growth figures out, it looks like there will be a year-on year fall in earnings. This is mainly due to the poor performance of a few sectors, particularly financials. Earnings’ growth, however, is looking to accelerate into the end of the year and into next year. This gives scope for the markets to rise without getting more expensive on a price to earnings basis.

The recent interest rate cuts by the Federal Reserve have brought some relief to the markets but people forget that we were and still are at historic lows and many companies have taken the opportunity over the past couple of years to restructure their balance sheets, increase dividends and buy back stock at record levels, leaving these companies in impeccable shape.

One of the current key concerns is the sub-prime mortgage sector and the rate of defaults. Pundits generally do not believe this will spread into the broader economy, lending standards have been raised and so the sub-prime problems should not be an ongoing concern. The problem is where all the repackaged mortgage debt is showing up. We have seen a greater than expected hit to the financial sector but no one knows the full scope of the fallout yet.

More of a worry than the effect of the sub-prime situation on the consumer is the amount of prime mortgages that are due to be refixed this year, many of which were financed in an ultra-low-interest-rate environment. It should not affect the default rate greatly, it could take its toll on consumer spending.

The level of M&A activity increase we are seeing year on year is a sign that the markets are offering value. Never before have we seen such a boom in the private equity sector, with many blue-chip companies being taken private. This has the effect of increasing liquidity. As a result, there is more money chasing fewer stocks, another factor pushing the markets higher.

But more recently, with the whole credit crunch, M&A activity has tailed off as it has been harder to raise funds.

If we do see the Fed continue to cut rates, this may have an effect on the carry trade, which could see the dollar depreciate further. This is concern for the non-dollar investor. In 2006, the dollar depreciated by 13.7 per cent against sterling so a sterling investor would have to see 13.7 per cent return on their investment just to stay level. However, if the dollar does depreciate, the value of international sales increases, raising profits for companies that have international exposure.

In summary, America remains a stable economy to invest in, with many good opportunities. Valuations are attractive on a historic basis, earnings’ growth is set to accelerate again and GDP is looking to stay stable for the reminder of the year and into next. The US markets have scope to extend the bull market rally we have seen over the previous few years.

Jonathan Aldrich-Blake is assistant investment manager of the Ashburton (Jersey) Americas equity fund

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