Timothy Wood
American notes
Stocks have likely seen their lows for the year and are showing value again.
That’s the view of Morgan Stanley as it tracks the fastest money supply growth
in 20 years even faster than the artificial increase engineered for Y2K.
The research is startling because it was taken for granted that the lax monetary
policy ahead of Y2K couldn’t be repeated. After all, it was responsible for an
unsustainable technology investment bubble that only popped late last year and
continues to bedevil investment scenarios.
The United States skirted outright recession in the first quarter with gross
domestic product (GDP) growth falling to a revised 1,3% from more than 4% a year
earlier. It hasn’t been pretty. Hundreds of thousands of jobs have been lost and
consumer confidence is in a trough. To boot, inflation is a nagging concern as
energy prices race away and productivity gains diminish. But the worst should be over, at least for investors.
A developing consensus among economists and analysts is that markets bottomed
out in March and April as shareholders responded to dramatic profit warnings and
company failures with capitulative selling. Combined first half-year profits for
the Standard & Poors 500 stock index are slated to be -9%, which will drag corporate profits for this year to zero or slightly negative. Technology earnings are set to fall by up to 40% for a truly miserable year.
Although corporate profits are likely to decline further this quarter, it will
only be because of a lagging effect. By the fourth quarter the easier money should have worked into the system to drive broad profitability. The picture is
a lot rosier for next year and profits are expected to recover into the teens a level more consistent with what was achieved in the 1990s. GDP growth is expected to hit 4% or better for the year spanning the 2001 to 2002 fourth quarters.
The gravity of the recessionary threat facing the US is all too evident in the
vigorous response of the Federal Reserve. Key monetary aggregates soared in the
first quarter in an effort to restart the stalled economy. The Fed has cut its
benchmark overnight rate five times this year to match declining three-month
treasury yields, lowering it by 250 basis points to a seven-year low of 4%. Futures contracts on the interest rate point to further cuts amounting to at
least three-quarters of a percent. United States President George W Bush’s tax
relief plan, worth $100-billion this year, will add further impetus to the monetary easing.
That easing is evident in the credit market, where loan refinancing activity is
running strongly, while consumer confidence is beginning to recover, although
spending is tempered by rising unemployment. Nevertheless, many firms are still
reporting difficulty hiring skilled staff.
Other indicators are also very bullish. The Treasury yield curve, a reliable
long-range predictor of economic performance hence company profits, has turned
strongly positive after being inverted for much of the latter part of last year.
Additional evidence of better times ahead can be seen in narrower interest rate
spreads a measure of the relative quality of government and corporate debt.
Higher spreads at the end of last year showed investors dumping corporate bonds
in favour of more reliable government issues. That trend has reversed and companies are actively seeking new financing with spreads down a third of a per
cent in the last month.
S&P 500 valuations are now considered at par to slightly under- or overvalued,
depending which model is used. But the consensus is clear. The extreme valuations achieved last year are a thing of the past as tech companies deflate.
That has left the overall market looking more appetising, at least if you’re
more interested in tracking indices rather than stock picking.
For stock pickers, Morgan Stanley believes the best gains this year will come
from utilities, healthcare, financials, energy and consumer staples. The anticipated worst performers are IT, materials and telecoms.
While the economic outlook is good, energy is the dangerous wildcard. The lack
of generating capacity and its resultant blackouts will ravage the performance
of the western US, but the real impact will be on discretionary spending with
fuel prices expected to double by August.