- As of 7 September 2012, the S&P 500 was just 8.1% away from its all-time closing high
- Even as the Eurozone’s problems have taken centre stage this year, consumption and investment have been resilient in the US, helping the economy post modest growth
- The manufacturing sector has shown some weakness over the past quarter, but we note that the sector’s representation in the economy has shrunk; the services continue to expand
- Corporate profits remain strong, and are at all-time highs; positive earnings surprises highlight pessimistic nature of consensus forecasts
- We maintain our view that the US economy will avoid slipping back into recession; risks from the “fiscal cliff” situation are troubling but manageable
- With earnings at record-highs, it will not be surprising for the stock market to follow suit
- Market valuations remain attractive but target upside has been lowered after strong run-up; maintain 3.5 star “attractive” rating, pending review at the end of the quarter
As of the market’s close on 7 September 2012, the S&P 500 stood at 1437.92 points, the highest level since January 2008 and just 8.1% below its all-time closing high (1565.15 points, on 9 October 2007). The US equity market’s 14.3% year-to-date gain (as of 7 September, in USD terms excluding dividends) has made it one of the best-performing equity markets so far in 2012, and investors may be wondering if the market still remains an attractive investment proposition. In this update, we provide a brief update on the US economy, and reassess the US equity market to see if it remains an attractive investment proposition.
“Muddle-through” economic growth
The story of US economy and its stock market so far this year has been one of persistent profitability of its corporations, despite “muddle-through” economic growth conditions. Despite the ongoing Eurozone debt crisis contributing to lower global trade and cautious business sentiment, the US economy has held up fairly well, recording quarter-on-quarter (annualised) growth of 2% in 1Q 12 and 1.7% in 2Q 12, a testament to the US economy’s resilience in the face of a challenging external environment.
Growth helped by resilient consumption, with credit growth recovering
This resilience comes as a result of the US economy’s large (and generally more stable) consumption base – US personal consumption expenditures are valued at about USD 9.5 trillion annually, making up over 70% of US GDP, and the segment has contributed an average of 1.5 percentage points of GDP growth over the first half of 2012. While consumption growth has not been all that impressive, it must be remembered that US consumers underwent an extreme period of deleveraging from 2008 (see Chart 1), with total outstanding consumer credit still yet to regain levels seen in early 2008, still representing a rather challenging environment for consumer spending.
Chart 1: Outstanding Consumer Credit
Investment also positive, assisted by residential investment
In addition to consumer spending, companies have continued to invest in new equipment and software, driving the investment component of GDP. Noteworthy also is the contribution of the residential sector, which has marked five consecutive quarters of growth, and contributed an average of 0.2 percentage points to overall GDP growth over the same period. As previously highlighted in How This Overlooked Sector Can Double US GDP Growth (Part 2), we expect the further normalisation of residential construction activity to continue to boost GDP growth, and data so far in 2012 has been supportive - the recovery of housing starts, falling inventory levels, along with the recent stabilisation of US home prices all point to further positive GDP contributions from the sector.
Chart 2: Housing Activity Recovering
But manufacturing turns south
Chart 3: Purchasing Manager Indices
However, latest PMI (Purchasing Managers’ Index) data for the US manufacturing sector in August marked three consecutive months of contraction, the first time since July 2009. While the ISM manufacturing PMI has historically been one of the key leading indicators of the US economy, it should be noted that the manufacturing PMI has crossed into contraction various times over the course of history without coinciding with a US recession (see Chart 3, with National Bureau of Economic Research defined US recessions highlighted in grey). Also, the size of the US manufacturing sector has fallen considerably over the years (see Chart 4), making up just 12.2% of the US economy (as of end-December 2011, down from 25.6% in 1947), although the sector still remains fairly sensitive to changes in the economic cycle. On a more positive note, a gauge of the health of the services (which make up the bulk of the US economy), the ISM non-manufacturing PMI, has logged 32 straight months of expansion, with the latest data point in August indicating a quicker rate of expansion for the segment.
Chart 4: Manufacturing Sector as a proportion of US economy
Persistent Profitability of Corporations, but expectations have fallen
In addition to the continued (albeit sluggish) economic growth posted by the economy, US corporations have managed to maintain profitability, growing quarterly earnings-per-share (for the S&P 500) to a record-high in 1Q 12 (see Chart 5). In the recent quarterly earnings season, 67.3% of companies beat forecasts, highlighting the pessimistic nature of consensus earnings forecasts under the uncertain economic backdrop. Nevertheless, consensus forecasts for S&P 500 earnings for 2012, 2013 and 2014 have declined -1.8%, -2.2% and -1.9% respectively on a year-to-date basis, an indication of more muted expectations for US corporate profits.
Chart 5: S&P 500 earnings at record-highs
No recession seen
Our expectations still remain for a recession in the Eurozone to be confirmed (see “Key Changes To Investment Outlook”), despite the latest positive developments (see “Has the ECB Found the Cure?”). This has undoubtedly had various negative implications for the US economy, with muted consumer confidence weighing on spending, while corporate investment also appears to have slowed given the economic uncertainties which have weighed on business sentiment. Hiring has also slowed, especially in recent months. At present, growth expectations for the US economy are understandably weak, with the consensus forecasting just 2.2% growth for 2012.
Chart 6: Investment still a far cry from previous peak
We maintain our forecast for the US economy to avoid outright recession, although the ultimate growth figures may be even weaker than what the consensus currently forecast should the spill-over effects from Europe be larger-than-expected. Historically, recessions in the US have been accompanied by sharp declines in gross private domestic investment, and even as real GDP has since surpassed its previous peak, investment still remains -15.8% below its March 2006 highs (despite having gained nearly 37% since 2009 lows, see Chart 6) – this low base makes it rather unlikely that the US economy will double-dip even if investment weakens over the next quarter or two, as the impact on overall GDP may not be significant.
“QE” should have little bearing, while the “fiscal cliff” situation presents challenges for policymakers
Investor sentiment has recently been boosted by talk of further quantitative easing measures by the Federal Reserve (which may be announced as early as this week), while the US “fiscal cliff” situation – where projected budget cuts (to stem the budget deficit) are expected to have a negative impact on GDP growth - remains an ongoing worry. We can only guess at the implications – should further bond purchases be implemented, the impact will be minimal considering that longer-term yields are already near historical lows.
Also, the Congressional Budget Office has projected a -0.5% economic growth rate for 2013 should a series of tax relief measures expire and spending cuts take effect, while also suggesting that real GDP growth could be 1.7% (under an “Alternative Fiscal Scenario”) if all expiring tax provisions were extended indefinitely, amongst other measures. In our opinion, it will be a very brave (and perhaps crazy) policymaker who will be willing to vote for measures which could result in a recession for the economy in 2013, and while the current situation presents a rather difficult dilemma for policymakers, we remain optimistic that growth in 2013 will be much closer to 1.7% rather than -0.5%.
Earnings drive stock markets; valuations remain compelling
Even as the S&P 500 approaches its historical highs, investors should remember that stock markets are ultimately driven by the earnings of the underlying companies (see “How Does One Predict Equity Market Returns?”), and with S&P 500 earnings at record-high levels, it is not surprising that the stock market has followed suit. As of 10 September 2012, the S&P 500 traded at PE ratios of 13.8X, 12.4X and 11.1X based on forecasted 2012, 2013 and 2014 earnings, suggesting that investors with a longer-term horizon are still looking at potential returns of about 35% by end-2014 (excluding dividends) should the market normalise to our fair value estimate of 15X for the US market (see Chart 7).
While the projected upside for US equities has diminished somewhat following the market’s strong performance this year, this still represents fairly attractive potential upside, warranting a 3.5 star “attractive” rating on US equities. We will review our rating on the market at the end of the quarter.
Chart 7: S&P 500 Valuations (as of 10 September 2012)