Market Outlook - US Equities - Greg Kerr


Here is a thought: imagine the world a year from now, November 2008. The global media will be saturated with coverage of the US election. Flags will be waving and US citizens will be reminded of the greatness of their country. Journalists and readers will have grown bored of stories of the US housing downturn, which by this time will have resulted in house sales falling for three years consecutively. Even if this is not the bottom of the housing cycle it is likely that the declines will be slowing down, enabling investors to at least anticipate where the bottom might be. As a point of reference, the average length of the residential construction cycle going back 50 years is two and a half years.

Investors will be looking to 2009 and reflecting on how the US economy is in fundamentally good shape, with unemployment low and US companies more competitive in the global marketplace thanks to the low dollar and rising Chinese renminbi. Export growth will have narrowed the current account deficit. The federal funds target rate will be low, with the Federal Reserve having reacted to the economic growth slowdown and housing crisis by easing monetary policy. Inflation may have picked up slightly thanks to the rising cost of imports but could be offset by oil prices, which may have fallen from the near $100 peak in November 2007.

What about the rest of the world? Europe could be facing its own housing crisis, with Spain, Ireland and the UK, for example, looking vulnerable, and China will have seen the Olympics come and go.

This description of the world in 2008 may be wrong in some details but the overall picture it paints is not unreasonable. Of course, this benign outlook could be quashed by wars, bird flu or an inflationary spike, to mention a few 'unknown unknowns', but from the current data a US growth slowdown is more likely than a US recession. The key point is that it is easy to paint a picture of how those investors who are attracted to momentum will be drawn to the US market over the next 12 months.

But what about valuations? Corporate America is today generating better cashflow return on investment (CFROI) than most countries in the world. Looking at Europe for example, not only are US businesses more profitable but they are also better managed - the improvement in CFROI has been better in the US than in Continental Europe even though it started from a higher base. Finally, although some claim that Europe is cheap relative to the US because it trades at 12 times 2008 profits estimates rather than 14, as measured by the Dow Jones Euro Stoxx 50 versus the S&P100, this masks the differing composition of the indices. More than one third of the value of the European index consists of lowly-rated financial companies compared to only 19% in the US index.

One approach to valuation comparisons is to look at the market-implied discount rate. This reveals that Europe is slightly more expensive than the US, which in turn is cheaper than it was in September 2002. Europe on the other hand is looking more expensive than it was five years ago.

So US equities are better quality, better managed and more attractively valued. In addition, investors can buy these companies at an attractive exchange rate. On a fundamental purchasing power parity (PPP) basis, the US dollar is cheap. Just ask any European who has recently been shopping in New York. On a real trade-weighted basis, the dollar is trading at a discount of around 11% to its 35-year historical average and is back below levels last seen in 1986. Indeed, the fall in the dollar during the late 1980s bears an uncanny resemblance to today's weakness and suggests that further falls are unlikely.

The conclusion from such analysis is as follows: the US represents an attractive investment today, in spite of its current problems. Those who worry about the cyclical peak in US corporate earnings and cashflows are ignoring the long-term secular trends of globalisation and increased supply-chain efficiency. The cycle has not gone away but it is less damaging than it used to be.

Greg Kerr is a US equity fund manager at New Star International

Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at 2 November 2007 and should not be interpreted as investment advice.