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The hard stuff

The market correction in February was telling. Many factors were blamed for the sell-off but one of the main concerns is the trend in US earnings which is definitively downwards.

Thomson Financial says at the start of the year, earnings for the S&P 500 for 2007 were expected to grow by 9.3 per cent but by late March the figure was revised down to 6.5 per cent.

It is small wonder that the market was spooked by Alan Greenspan’s prognosis of a one in three probability of a US recession this year. There is a danger that investors extrapolate the downward trend in earnings’ growth.

Are there any hints that the US economy is heading for a hard landing? The US Federal Reserve’s mild change in language has been interpreted by some that economic growth – and not inflation – may be the main concern. Fed governor Ben Bernanke noted the risks around the central forecast have increased and cited weakness in sub-prime mortgages and business investment as the main concerns.

We believe it is the latter factor that the Fed really has its eye on as there is a close correlation between job losses and a tail-off in business investment. If investment begins to slow markedly, we believe this would prompt the Fed to cut rates.

We anticipate a further equity market correction in the third quarter of 2007 as the decline in earnings is extrapolated by investors. We have taken some risk off the table by reducing some of our higher-beta positions in funds exposed to Eastern Europe.

But there are reasons to be optimistic. A cut in the Fed target rate would be likely to improve the competitive position of the US, help boost US exports and counterbalance some of the weakness from lower business investment. It would also be a fillip for the stockmarket and create cheaper financing for corporate activity. In addition, economic data from the UK, Europe and Asia remains robust. Desynchronised global growth, in which the US is slower while other regions take up growth baton, could have useful implications for inflation and could be a step towards a more balanced global economy.

We are not predicting a recession and are maintaining our longer-term holdings in commodity-focused funds such as ACDS Australian Natural Resources and exposure to fast-growing markets with considerable earnings’ growth such as China through Atlantis China Fortune. We continue to prefer exposure to equities over bonds as we see little value in bonds unless the Fed cuts rates aggressively. The watchword is caution in avoiding the herd reaction that fails to differentiate between a slowdown in earnings’ growth and a fall in earnings.

Mark Harris is head of New Star Asset Management’s fund of funds team.


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