Although emerging markets are currently in favour, Tom Stevenson argues that 2011 could well be a successful year for the US stock market.
Hosting a debate between a panel of fund managers and asset allocators recently, I was struck by the unanimity of their views on what would be the best-performing geographic area this year.
Emerging markets, especially in Asia, were top of everyone’s list for 2011. The US did not get a mention.
That set my contrarian antennae twitching, with recent events suggesting that this year might be a good one for investors in the world’s biggest stock market.
Politics, monetary and fiscal policy, corporate strength and valuations point to the US market ending 2011 significantly higher than where it started.
The US electoral cycle has tended to favour the year after the mid-term elections, especially when a lame duck president is forced to do deals.
Last month’s fiscal package represented a significant back-down by President Barack Obama, and the extension of George Bush’s tax cuts beyond their planned end-2010 expiry removes one of the biggest obstacles to continuing economic recovery.
The biggest surprise in the package was a 2 per cent cut in payroll taxes that gives the economy a US$120 billion (A$120 billion) annual boost.
What this means is that the outlook is clearer in the US than almost anywhere else in the world. For instance, Americans will not experience the fiscal austerity that is being imposed in the UK.
They will not experience the sovereign debt worries afflicting Europe (although the US$900 billion increase in the US Federal deficit as a result of last month’s measures will bite at some point).
Nor will they face the inflation concerns hanging over China and other emerging markets.
Inflation is running considerably below the Federal Reserve’s implicit target of about 2 per cent, despite the US cash rate having stood at an effective zero rate for two years.
Goldman Sachs thinks the rate will stay there for another two years, but the unexpected jump in 10-year government bond yields in many countries shows how external events can affect interest-rate forecasts.
But with US unemployment apparently stuck at the historically high rate of around 10 per cent and the real rate of under-employment much higher still, I cannot see interest rates rising much in the US for the foreseeable future.<!–
Low interest rates, which have allowed companies to refinance their debt on favourable terms, have contributed to profit margins rising to near-record levels.
This trend has been underpinned by the rapid response of companies to the business downturn, the flip side of the high unemployment rate.
The net result has been that margins bottomed out much higher than in the recessions of the early 1990s and in 2002.
The perfect combo
This rebound in margins means that the average earnings for the constituents of the S&P 500 Index should be higher than at the previous peak in 2007, and around one-and-a-half times higher than in 2000 when the US stock benchmark hit a peak of 1,527 (21 per cent higher than its level at the end of 2010).
Although valuations were excessive when the S&P reached this record in 2007, the combination of a lower market and higher earnings means that shares are better value today.
With earnings expected to grow at a double-digit rate this year and next year, the multiple of earnings that investors will be prepared to pay could also rise.
It is this combination of higher earnings and a rising price-to-earnings ratio that often characterises the best years in the market.
A final reason 2011 could be America’s year is the sheer weight of money that is sitting on the edge of the equity market. I think that the rise in yields on government bonds in the first half of December might mark a watershed moment, as investors start to ask themselves whether they have got their money in the right place.
After a couple of years of outflows from equity mutual funds, the tide is turning as investors accept that they have to move into riskier assets if they are to hope to replace the income they have lost from their risk-free deposits.
If rising bond yields change the perception that fixed income is a safe proxy for cash, the US equity market could receive a significant injection of new money this year.
Easy money, decent growth, reasonable valuations and indifferent investors make an interesting combination.
Tom Stevenson is an investment commentator at Fidelity.
