RCM U.S. Strategic Outlook
Q2 2008
Corporate Profits
Consensus sell side analyst bottoms up expectations for 2008 earnings growth are nearly 13% and contrast with 6% top down. A sharp second half 2008 recovery is expected in the financial and consumer discretionary sectors. Distress in the credit markets is likely to weigh on financial sector earnings and may also constrict consumer discretionary earnings, at least until sufficient Fed easing has reduced lender risk perceptions and rebuilt bank profit margins. Analysts are likely to continue downwardly revising 2008 US earnings estimates as recession fears spread.
Pricing/Inflation
Energy and food price inflation has surged and will continue to keep headline inflation readings above 3% range until supply/demand and speculative pressures abate. In contrast, core inflation pressures have remained fairly stable, and will recede again as economic growth remains substantially below trend. Labor compensation pressures should also continue to recede into early 2008 as the unemployment rate rises further. Management cost cutting efforts should insure that labor productivity continues to accelerate – just the opposite of the stagflationary ‘70s.
Interest Rates
With the deterioration of credit conditions and slower job growth, the Fed is likely to continue its easing campaign through most of 2008. With the sharp shift to a more risk averse position by bank lenders, the Fed will need to lower the fed funds rate fast enough to improve lender perceptions of the profitability of new loans. A fed funds rate below 2% by year end is not out of the question as the Fed tries to stabilize the housing market, which in the past, has been the main transmission mechanism between Fed policy and economic growth.
Economic Activity
Real GDP momentum (year/year % change) is likely to continue winding down and should stabilize around 1% by midyear 2008. The erosion of the labor market and the onset of a credit crunch places real consumer spending growth, which has proven remarkably stable in the 3-3.5% growth range for the past 3 years, seriously at risk. ISM new orders are rolling over, and with earnings growth in question, capital spending is highly unlikely to pick up the slack of a slower consumption trajectory. The trade deficit should continue to improve with slower consumer imports and still vibrant export growth.
International
Growth in the emerging market economies has remained fairly resilient against the slowing in US final demand and import growth. Decoupling is not, however, the case amongst G7 economies, where Japan is showing the most weakness. Credit market distress is likely to lead to monetary policy ease in the UK and Europe, while growth in Asia ex Japan should remain well above that of the US, Europe, and the UK at least until midyear.
Dollar
With the US trade deficit visibly improving, the rate of dollar depreciation should remain gradual but persistent. Dollar depreciation helps US earnings growth and makes US asset appear less expensive to foreign investors and acquirers, but it also introduces currency losses for existing foreign holders of US asset that are not fully hedged. The risk this introduces is that at some point, foreign holders of US dollar denominated assets reduce their portfolio preferences for these assets, en masse. Similarly, a sudden expansion of the Fed’s balance sheet – which is not yet occurring – could induce a flight from the dollar.
Valuation
The S&P carries an overall forward P/E ratio in the 13-14 times range on consensus sell side operating earnings estimates, which is very near its historical average. The deployment of existing cash reserves and incremental free cash flow in large share repurchases and higher dividend payments, along with continued strategic acquisition activity and lower interest rates should encourage a higher multiple on the S&P well into 2008.
Technical/Sentiment
Technical measures of equity index trends are have moved heavily into bearish territory. The distribution of corporate free cash flow to investors is still likely to remain healthy in 2008. US household portfolio preferences may also continue to shift away from real estate toward equities as home prices remain under pressure. Eventually, a lower Treasury yield environment may also encourage asset allocation shifts towards equities as low yields make it difficult once again to hit target returns through fixed income exposures.
Fiscal Policy
The fiscal deficit should start to widen with the Q2 tax cuts and the normal shrinking of tax revenues that accompanies slower economic growth. Monetary policy alone is unlikely to stabilize the housing market, and innovative measures designed to reduce the pace of foreclosures and ease mortgage servicing burdens are likely to pass in Q2. Front runners in the primaries appear to have a more populist economic orientation which may prove more worrisome to investors as economic platforms are nailed down after the primaries. In particular, some form of massive reregulation of Wall Street and the financial system is nearly inevitable.
