Interactive Investor

Is the bull set to run, or increasingly fenced in?

28th November 2014 09:05

Edmond Jackson from interactive investor

Well they would say that, wouldn't they? According to Goldman Sachs the US is set to drive years of prosperity - with a rising dollar, economy and stockmarket. "Investors may be under-estimating the scope and persistence of that trend" meanwhile "euro downside remains our top conviction view." Sterling should trade strongly versus the euro, but is overall at risk from the UK running the worst current account deficit in the developed world, at about 5.2% of GDP. On this basis you had better consider more US exposure, e.g. plant hirer Ashtead Group, Apple or a US equity fund. Morgan Stanley is similarly bullish, reckoning the S&P 500 index will rise another 50% by 2020.

Yet a survey of business confidence across 6,100 firms globally by Markit Economics shows optimism fell in October to the lowest since the survey began five years ago.

"The most striking development was the extent of downturn in the US, where optimism hit a new survey low, with the service sector seeing a particularly dramatic decline." Managers' worries include higher interest rates, on-going tensions over Ukraine and the Middle East, and political uncertainty in the US, UK and Japan. Hiring and investment are cited at or near post-2008 crisis lows, likewise expectations of US business activity despite the Federal Reserve's $3.7 trillion total stimulus.

Firms expecting activity to be higher in a year's time exceed those expecting a decline, by 28%, but the net balance has slipped from 39% last summer. Sentiment in industry therefore differs markedly from finance, with the S&P 500 index testing an all-time high and investment banks in "new era" mode.

Mind how this coincides with reduced QE stimulus

Now the US Federal Reserve has exited its $85 billion a month, bond buying/money printing programme, there is not much else by way of global stimulus. It remains to be seen whether the European Central Bank (ECB) can launch genuine QE without the Bundesbank in support; and although Japan's has added some $12 billion equivalent a month to its bond purchases, its capital markets are not as open or sizeable as the US. So mind the risk of an inflection point with the US monetary spigot turned off, its stockmarket at an all-time high and business sentiment turning down. Internationally the excess of dollar liquidity that drove emerging markets' credit boom is over, so in relative terms it's possible monetary tightening is underway.

The US remains the most significant economy and stockmarket

The consensus view is the US as a "recovery-to-growth" success story. "Dr Doom", the economist Nouriel Roubini, credits how the "single-engine global economy" involves only the US and UK functioning effectively. The eurozone has stalled, being one shock away from deflationary recession; Japan is struggling; and emerging markets are slowing rapidly. "So the question is whether and for how long the global economy can remain aloft (like a jetliner) on a single engine." Mind how trends - especially changes - in the US stockmarket are quickly reflected more widely.

Jerome Levy Forecasting also counters US cheerleaders

This independent consultancy which anticipated the 1929 and 2008 crises, posits a 65% chance of global recession forcing a contraction in the US by end-2015.

Its half-dozen analysts consider the US and other advanced economies, have balance sheet excesses with limited scope to tackle deflation or other risks; also that US companies nowadays have a large overseas earnings element, and US consumers are highly exposed to the stockmarket. These analysts are conservative, they have over-cautioned before, e.g. citing a 60% chance of another US recession in September 2010 - after which an upturn followed. Forecasting will always be hazardous: you can but test predictions against what evolves, and change your view according to the facts.

Still no real trend of company profit warnings

I notice outlook statements being generally cautious with managers aware of political/interest rate risks especially. The general theme is 2014 earnings in line with expectations, there is no real trend of warning on 2015. Any nasty surprises are industry/company specific: for example in the US, shares in Deere & Co plunged after the company warned on the farm-machinery market although it had been boosted by exceptional demand for corn and tax breaks on machinery investments. Deere's 2015 earnings expectations are still well short of the analysts' consensus, showing how shares can react sharply where forecasts are exposed.

Similarly among UK-listed cyclicals, I have noted how Asian and European deflation was reflected in cautions from Electrocomponents and Premier Farnell, mid-cap distributors of electronic components which can be straws in the economic wind. The only recent UK-listed shocker has been Petrofac downgrading its 2015 outlook for oil services, although this looks specific to oil price weakness affecting investment, and the company's project management appearing less capable.

Lower oil prices may be a net positive for the global economy: some economists reckon the recent $30 drop transfers $400 billion equivalent from oil exporting nations to importers over a year, hence winners and losers but overall more scope for spending. In particular, some 2.5% of Chinese GDP is spent on net oil imports and this marginal benefit from lower oil prices is significant just when China needs to sustain growth to manage its debts. In the UK, however, sub-$80 oil puts development of remaining North Sea reserves in question, adding to risks with the UK balance of payments deficit.

Nor are company directors generally off-loading stock

The Markit findings on management expectations do not appear to be prompting a pattern of share selling; any major trades being company/industry specific. Notably the finance and operations director at retailer Ted Baker has sold £922,500 worth of shares at 2,050p to own 81,039 shares worth nearly £1.7 million; this coming only a week after a strong third-quarter trading report albeit weeks before the key Christmas period. The stock has since strengthened to about 2,160p, 23 times the 12-month forward earnings expectation. With annual earnings growth projected to moderate to the percentage high teens, it's not too surprising the finance director is hedging his bets.

UK reverting to over-reliance on consumers?

The July-to-September period has seen a 0.7% slip in UK business investment with consumer spending up 0.8%. - compared with a 3.3% rise in business investment in April-to-June, the fastest pace in nine years and heralded as proof of a better-balanced UK recovery. Most likely, the slip connects with caution as reflected by the Markit survey. It would be premature to read much into one quarter's change but without real wage growth the UK economy cannot progress by relying mainly on consumers and government spending. Perhaps that is also in the mind of Ted Baker's finance director.

A "Santa rally" there may be, but keep your eyes on the variables noted here - as the real drivers for equity value.

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