RCM U.S. Strategic Outlook
Q3 2008
Corporate Profits
Pro forma top down S&P 500 earnings for 2008 should be slightly higher than 2007 as financial write-offs are reduced. A sharp second half 2008 recovery is expected in earnings for the financial and consumer discretionary sectors. Distress in the credit markets is likely to weigh on financial sector earnings, and weakness in the labor market 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, and reductions to 2009 expectations may begin by Q4 2008. S&P operating earnings in 2009 could be $100 per share or 5-10% higher than 2008.
Pricing/Inflation
Energy and food price inflation has surged and will continue to keep headline inflation readings above 3% supply and speculative pressures abate. In contrast, core inflation pressures have remained fairly stable, and are likely to recede again as economic growth remains substantially below trend. Labor compensation pressures should also continue to recede 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 1% 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 activity.
Economic Activity
Real GDP momentum (year/year % change) is likely to continue winding down and should stabilize around 1% by late 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 later in 2008, while growth in Asia is threatened by policy responses to higher inflation in the region, as well as slowing export growth to the G7.
Dollar
With the US trade deficit visibly improving, and central bank easing due in the rest of the G7, dollar depreciation should be less dramatic in the remainder of the year. 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 14-15 times range on consensus sell side analyst operating earnings estimates, which is very near its historical average. Share repurchases remain high, but acquisition activity has dampened down, while recapitalization efforts across the financial sector have stepped up in recent months introducing dilution in one of the larger segments of the equity market.
Technical/Sentiment
Technical measures of equity index trends have moved heavily into bearish territory. US household portfolio preferences may also continue to shift away from real estate 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 is widening 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, as are measures to buttress the GSEs. A more populist economic orientation may prove more worrisome to investors as economic platforms are nailed down. In particular, some form of reregulation of Wall Street is nearly inevitable.
Past performance is no guarantee of future results. This document contains the current opinions of RCM and such opinions are subject to change without notice. This document has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
