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8 January 2007

Investors prepare for soft landing scenario

“Higher energy prices and interest rates, and a weak housing market all have a lagged effect”

The US market has risen nearly 14% during 2006. However despite the headline figure, sterling investors have had to contend with a 14% depreciation of the US dollar. Consequently, the US market has actually made a slight loss in sterling terms.

While this highlights the risk of international investing and the need to diversify across regions, currency markets are extremely efficient and forecasting future moves is challenging. That said, it is difficult to see the US dollar depreciating significantly from these levels against either the pound or the euro.

Looking ahead to 2007, we are more cautious. The US stock market is starting the fifth year of its current bull market which is mature when compared to previous market cycles. Similarly, the current economic expansion of about five years is also longer than previous cycles. Over this period S&P 500 earnings have risen by over 200%, real GDP income has risen by 17% and the stock market has risen over 80%.

All of these are comparable to previous cycles. This does not mean the market cannot rise further; valuations are not at extreme levels, as is often the case when the cycle peaks, and the last two economic expansions both lasted nearly 10 years, although these were unprecedented.

However, valuations are not compelling and although macroeconomic data continues to suggest a soft landing ahead it appears that most investors are predicting such a scenario, and this appears to be priced into current market levels.

The market also looks to be pricing in an interest rate cut in the first quarter of 2007. This may be optimistic: the Fed has kept rates on hold at 5.25% since June and there is not yet a clear case for the committee to cut rates, particularly with exchange rates at current levels and wage inflation rising at 4% plus.

On a more positive note, short term indicators, including sentiment and technical readings, suggest the stock market could make further gains over the next three to six months but we expect this to be followed by a period of consolidation.

The primary near-term debate is based around the weak housing market and related consumer spending, particularly as the consumer accounts for two thirds of GDP. US savings as a percentage of disposable income has been negative for the past two years and personal wealth has fallen as house prices depreciate.

Despite this there has been just a modest slowdown in consumer spending. Higher energy prices and interest rates, and a weak housing market all have a lagged effect and there may be worse to come.

From an industry perspective we continue to avoid consumer discretionary names, despite their strong performance in the last quarter of this year, for the above reasons. We have a significant amount of money in US healthcare as we feel there are several names that offer good value with the potential for positive surprises over the next 12 months, including biotechnology company Amgen and pharmaceutical Wyeth.

We also hold energy names but a lot of this is through services and equipment companies including Smith International and TODCO that will both benefit from high capital expenditure from the oil producers. Our technology holdings are stock specific as various sub industries have different fundamentals.

Bull Points

• Short-term market indicators positive
• Valuations not extreme
• Soft landing probable

Bear Points

• Stock market and economic cycles mature
• Interest rates on hold
• Consumer weakness

James Kinghorn
Senior Investment Manager- US equities
The Scottish Investment Trust PLC

Published in Investment Week

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