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11 February 2004

US economy remains on growth path

Cost cutting and restructuring have resulted in higher levels of corporate profitability

With the technology heavy NASDAQ having reached a 30 month high and the S&P 500 a 22 month high, the spectacular stock market rebound of 2003 has continued into the early part of 2004.

It is worth noting that while the NASDAQ is still 58% adrift of the extreme levels seen in March 2000, the broader S&P 500 index is 26% below its all time high.

Macroeconomic news remains positive and this has helped fuel the market's momentum. however it is corporate earnings that have provided the catalyst for market gains. Year-end results are again beating estimates providing further evidence that the US economy remains on a healthy growth path.

GDP for the fourth quarter of 2003 is expected to be 4% and for 2004 economists expect GDP growth of 4% - 5%. Fiscal and monetary stimuli provided by the Government and the Federal Reserve are having the desired effect but both are looking for indications that businesses are hiring again.

With an election in November the chances are that interest rates will remain low and job growth should become more evident as the year progresses.

Earnings continue to surprise positively and few predicted the impact operating leverage would have on the bottom line. Cost cutting and restructuring in the recession have resulted in higher levels of corporate profitability as end-demand recovers. In addition, currency moves may boost reported profits.

With corporate spending on the rise and low interest rates, prospects appear solid. However, the second half of the year may be more challenging.

Operating margins are back to, or higher than, historic levels and while the current favourable economic environment may be able to support above-average margins, only the information technology and materials sectors appear to have room for further significant margin expansion. As a result we should expect earnings growth to slow in the second or third quarter of 2004.

As a whole the US market does not look undervalued. While economic growth remains strong, there are several factors that may weigh on the market later in the year.

First, there is the prospect of rising interest rates; on top of this the size and growth of both the budget and trade deficit remain a potential problem.

The president, in his recent State of the Union address, promised to cut the budget deficit in half within five years by reducing discretionary spending. A weakening dollar will help close the trade deficit but more extreme measures and policies will probably be required to balance the two.

Other warning signs include the high level of insider selling, investor sentiment indicators suggesting excessive market bullishness and earnings forecasts starting to look aggressive.

These are unlikely to hinder gains in the short term provided news flow and earnings growth remain solid. Nevertheless the IT sector, despite having the best fundamentals, looks to be pricing in a further significant improvement in profit growth.

Industrials look more attractive as they will continue to benefit from further growth in capital spending.

Healthcare should benefit if investors start to rotate out of cyclical areas. Over the next six months investors may be inclined to start taking some profits from the US.

James Kinghorn
Investment Manager
The Scottish Investment Trust PLC