FYI | Aug 17 2009
By Chris Shaw
As at July 21st the US S&P500 Index was actually up 5% for 2009, thanks to a rally of more than 30% from the low of 666 points reached early in March. Despite the magnitude of the rally global investment manager Janus Capital Group points out the index remains around 40% below its highs of October 2007.
The June quarter run in the group’s view was driven by the end of the “end of the world” trade – capital markets reopened and many companies were able to refinance or raise capital, and as their financial positions improved investor expectations also recovered from what had been very bearish levels.
The rally has continued into the September quarter thanks to largely better than expected US earnings reports as companies have held costs in check even as they reported little in the way of top line growth. US financials in particular posted solid earnings numbers in the group’s view.
Given the recent gains, Janus is now turning its attention to whether or not the current market fundamentals support a continuation of the rally and in its view the most important variable here is employment. Both non-farm payrolls and the unemployment rate continue to paint a negative story, especially as since the beginning of 2008 there have been more than 6.4 million jobs lost in the US, pushing unemployment up to near 10%.
As consumption is driven by employment trends the group suggests some caution with respect to the economic outlook is warranted, especially as consumption accounts for 70% of US GDP.
At the same time there are negative consumer price trends as businesses are having to cut prices, which has a flow on impact on margins but also implies near-term real interest rates are actually high at around 5.0% at present. While the group doesn’t see inflation as a big problem it does see the US Federal Reserve as retaining its current accomodative stance on monetary policy for some time.
This policy has seen the Federal Reserve’s balance sheet expand to an all time high, while US debt levels have also blown out as more and more liquidity has been forced into the financial system since the sub-prime crisis took hold. Offsetting this increase in debt has been lower household and corporate debt levels as both groups look to de-leverage their respective balance sheets.
This trend should reverse once the Federal Reserve eventually starts to tighten policy, which is likely to coincide with an increase in borrowing activity from both households and corporates. In other words, the group suggests the key to renewed economic expansion will be when households and businesses begin to again increase their leverage.
Looking at the market sectors the company covers, it notes the IT sector is now showing signs of stabilisation in company budgets but the larger companies remain the best placed to gain or maintain market share. Smart phones should be the major growth sector, while an increasing trend to remote storage of data is likely to mean higher levels of infrastructure investment and improvement in software for security and network optimisation.
While the outlook for the financial sector has improved, Janus doesn’t see it as all smooth sailing given the non-performing loan cycle has not yet run its course. A steeper yield curve and higher spreads on loans have improved capital structures in the sector, so the group has added some risk to its portfolio.
The group remains long-term bullish on the oil price but notes the re-pricing in recent months has added some short-term concerns, especially in relation to demand for refined products. As a result the group is more cautious now on oil companies.
There is still little reason according to Janus for any quick recovery in the communications sector and it also continues to point to a sector of two categories – companies in cyclical declines and those facing structural declines. Some of the former offer good leverage to a recovery given current cost cutting measures while among those in the latter category, the search continues for those likely to be long-term winners from the changes taking place.
As consumer demand has not yet recovered, Janus remains cautious on the consumer sector, though it likes the outlook for spending in emerging markets at present. Given its concerns the group is continuing to focus on those brands that can gain or hold market share in the current tough conditions.
Among the industrials the group takes the view the earnings downgrade cycle is now complete, meaning there are some opportunities to identify those companies where future outperformance is possible. Its bias at present is towards early cycle companies, which includes the likes of freight forwarders, while it also has some interest in auto and auto parts stocks.
While an aging population is one driver of the healthcare sector the group also notes efforts at healthcare reform are also impacting. Given a recent lack of interest in the sector Janus sees this as one sector of the market offering a number of opportunities at present, especially as any reforms are unlikely to go far enough to destroy profitability to the extent the market currently expects.
Looking globally, Janus suggests Japan continues to have economic issues as slow growth is generating an over-capacity position, a problem it expects will continue for some time. Emerging market growth is an offsetting positive, though there is scope for China to overheat on the back of the fiscal stimulus program in the group’s view. It continues to expect European economic growth will lag that of the US.
In conclusion Janus suggests while the latest corporate earnings were supported by cost control rather than top line growth this trend cannot continue indefinitely. At the same time the mixed economic signals suggest something of a stock-pickers market, espcially given earnings expectations are very wide at present thanks to a lack of earnings guidance from companies. If the market continues to rise it sees a growing risk of disappointment from either an earnings or economic perspective.
