HEADWINDS AND TAILWINDS

World markets in balance over American rumblings

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The US equity market has not seen a 10% correction since 2011, leaving many to feel that it is vulnerable to a sell-off. When and how a correction will happen cannot be forecasted with any accuracy, and there are many factors that could cause a sell-off in the short term (for instance an oil price spike if the turmoil in Iraq escalates greatly).

Rather than trying to time the market, investors are better off focusing on valuations, having a long-term view and trying to understand the underlying drivers of market performance.

Factors supporting the rally

Since 2009, US equities have had a number of broad tailwinds. These include, firstly, the fact that after the crash, shares were cheap. Secondly, there was modest top-line growth (revenue growth) as the US economy improved gradually while several emerging markets continued growing well.

Thirdly, and probably most importantly, was robust bottom-line (profit) growth as companies were able to slash labour costs and increase margins to record levels. Low interest rates also made it cheap for firms to buy back large quantities of their own shares, boosting earnings per shares (EPS) growth. Companies also sat on record cash piles.

According to a report in the Financial Times, US share buybacks and dividend payments climbed to a record level of $241billion in the first quarter of 2014, as companies chose to boost shareholder returns (though it has to be pointed out that the previous record of $233billion was set in the third quarter of 2007, which was pretty much at the top of the cycle, thus destroying shareholder value).

Over this period, there have also been several headwinds, leading to “risk-off” periods, particularly with regards to the severe cutback in US government spending and several episodes of political uncertainty surrounding government spending (such as the fiscal cliff, the US downgrade and the debt ceiling).

There were also fears of a double-dip recession in the US (Europe and Japan did experience double-dip recessions). Since 2009, large numbers of individual and institutional investors were net sellers of equities despite the rally.

Looking ahead, some tailwinds could become headwinds. US equities are no longer very cheap compared to history, but still cheap compared to bonds. Corporate margins can narrow, though not necessarily by much as labour’s share of national income is structurally depressed by competition from technology and the global pool of cheap labour.

These headwinds could be offset by other tailwinds, including mergers and acquisitions activity and capital expenditure. These are two different ways for companies to grow revenues, by buying competitors or by expanding the firm’s own capacity or enhancing its productivity. Companies sit on large piles of cash so they can afford to ? (as is evidenced on the large amounts currently spent on share buybacks).

Capital expenditure in particular remains very low compared to past cycles, and could support future economic growth. Mergers and acquisitions can also keep margins high due to cost savings, but the promised cost savings or “synergies” often fail to materialise.

Future path of interest rates crucial

Key to the rally is the future path of interest rates, as premature interest rate hikes could do some serious economic damage. The market currently expects the first hike in the Fed funds rate to occur in the third quarter of 2015. This is in line with the Federal Reserve’s own current thinking and guidance. However, headline inflation in the US has now risen to 2%, which could start putting pressure on the Federal Reserve. There is an increasing concern in central bank circles that certain asset prices might be in bubble territory. Unemployment is also falling rapidly.

However, both headline unemployment and inflation numbers hide underlying economic weakness in the US economy, which is expected to grow around 2% over the medium term. While last week’s policy meeting resulted in the Fed cutting back its bond-buying programme by another $10 billion to $35 billion a month, the Fed remains committed to accommodative policy, which is good.

But if the Fed (or other major central banks) loses its nerve and hikes unexpectedly, early or harshly, the market could be hit hard.

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