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12 June 2006

May sees sharp correction in US market

"Higher interest rates and oil prices are having a noticeable negative effect on US consumer spending"

The US market, along with most other major international indices, has experienced a sharp correction during the month of May.

The primary concern for investors has been strengthening inflation data and this in turn could send interest rates significantly higher. Inflation numbers have looked largely benign over the previous few months but there are several sources of inflation risk, including: continued high commodity prices, rising wages with the US near full employment, and potential weakness in the dollar resulting from the persistent twin deficits.

It is well known that the new Federal Reserve chairman, Ben Bernanke, targets inflation and this will be a critical factor in determining the extent of further rate rises. Wages-related employment costs are typically a major threat to corporate profitability and this will be a key number to watch going forward.

The economic expansion cycle is mature but the economy is still growing at a solid rate, and we anticipate between 3% and 3.4% real GDP growth this year. Earnings trends also remain strong but we would expect to see profit margins come under pressure as inflation rises. However it is worth remembering that 40% of S&P 500 earnings are generated overseas and global GDP growth should exceed US GDP growth over the next two years. Therefore, US corporate profit growth can exceed domestic economic growth.

While the effects of 16 successive interest rate hikes have had a modest impact on the US economy as a whole, higher interest rates and oil prices are having a noticeable negative effect on US consumer spending. This is being reflected in weak operating results from many consumer discretionary companies.

More positively, although broad liquidity measures are exhibiting negative trends, strong corporate balance sheets and private equity firms with large cash positions should provide significant support for the market. Corporate net equity purchases are at record levels. Corporate free cash flow yields are healthy and the recent market correction may spark a more aggressive round of M&A activity.

While market valuations are not extreme it should be borne in mind that earnings are well above trend levels. As broad liquidity measures decline, and inflation and interest rates increase, the market multiple may contract. This means that strong earnings growth and positive earnings surprises will need to drive the market higher. We feel that this may be challenging: operating margins are near record levels and analysts' estimates for 2006 appear quite aggressive, potentially leading to disappointments later in the year.

As a result we have become more cautious on the US market and have been switching into more defensive names, primarily in the health industry, which has been a notable underperformer over the past 12 months. We like the combination of more attractive valuations and stable growth profiles that many of these companies offer. Accordingly we have reduced our positions in the cyclical names that have performed well over the last couple of years, and have minimal exposure to consumer related stocks.

James Kinghorn,
Investment Manager US Equities
The Scottish Investment Trust PLC

Published in Investment Week

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