Negative news, positive impact

Global investors have done well by avoiding US equities over the past few years. However, it seems the tide is turning and US equities are more likely to perform better than other major markets in the year ahead.

The reason is because of a difference in interest rate outlooks. Europe’s rates are expected to keep rising for a while yet, as do Japan’s. Australian interest rates may rise another 25 basis points later this year. The US, however, is generally believed to be at or close to its peak. This is good news for US equities.

History shows that whenever the threat of further rate hikes falls away, US equities can stage firm advances. Experts such as the US strategy team at Smith Barney Citigroup or their peers at BCA Research believe current potential upside for the US sharemarket is about 10%.

The major threats to this scenario are an unexpected outbreak of price inflation in the months ahead or a recession ("hard landing") instead of slowing economic growth ("soft landing") for the US.

Usually, the US Federal Reserve pausing in its monetary tightening process is enough to prompt the sharemarket to rally. That is because history shows such a pause is usually followed by a rate cut. Investors are likely to assume that history will simply repeat itself, until they receive proof of the opposite.

To contain inflation, the US economy now has to slow down. This will allow the Fed to stick to its pause until the US economy is in need of extra support again, and that will be the sign for the Fed to start cutting interest rates.

A gradually slowing economy means sales and margins of a growing number of US companies will come under pressure. Lesson one is, therefore, to look for US companies with offshore leverage, especially because the US dollar is widely expected to enter another period of sustained weakness again.

In a lot of ways, the US investment story is similar to the one in Australia: it is safer to avoid consumer oriented sectors, and to keep away from housing or building materials; prefer quality juggernauts to feisty small caps; and remember that international earnings with real pricing power beat anything else. Expect capital management to figure prominently in the year ahead as well.

At face value, it would seem there's plenty of room for bad news coming from the US. Current analyst forecasts are for an average earnings per share (EPS) growth of 12% for fiscal 2006-07. The following year should see even higher growth. The coming months will confirm whether these expectations are realistic, but the odds appear to be in favour of lower growth, especially for domestically focused companies.

Analysts at BCA Research, for example, have studied on a few possible scenarios for the year ahead. Their most optimistic scenario sees 5% EPS growth, on average, which is less than half what securities analysts are expecting right now.

But no matter how far or how low corporate earnings will stretch in the year ahead, the key component in the outlook for the sharemarket remains a stabilising rate of inflation or, even better, a declining one.

The end result should be higher price/earnings (P/E) multiples, which should compensate for lower earnings. In other words, as the market will become confident that the next move in interest rates will be down, it will re-rate the sharemarket, with investors willing to pay higher multiples for future growth. This re-rating process usually outshines the fact that profit growth is in decline.

The exception is when inflation picks up again, which would result in the true horror scenario of lower earnings (growth) in combination with rising bond yields (because of rising inflation and thus rising interest rates). Under such a scenario the market would be hit by a double whammy as both market multiples and earnings are trending lower. This is what happened in the 1970s. As a result, US equity markets recorded a negative performance in the year after corporate earnings peaked during the 1970s era. The same thing happened in the mid-1960s, for exactly the same reason.

If inflation remains contained, and history can be taken as a guide, the outlook should be for a strong performance for US equities. On BCA Research calculations, the average rise for the S&P500 index in the 12 months after US corporate earnings peaked, is 10%. This becomes 19% after two years and 30% after three years. If we take out the three negative years when inflation was on the rise, the average rise for the index in the first year jumps to 21%.

Whether it will pay off for Australian investors to shift part of their funds towards the US market is, however, far from certain. The US dollar is expected to resume its downward path again. While this will benefit US companies selling abroad, or even US investors investing elsewhere, it will diminish the returns of Australians in the US market.