Land of plenty cannot be ignored

Despite poor performance in 2006, the American market offers opportunities for investors, with high-quality companies available on attractive valuations and above-trend economic growth.

The American equity market is simply too big for British investors to ignore. While opinion remains divided about the enduring health of the world’s largest economy, there is good news for those actively seeking exciting growth opportunities.

So why should investors continue to back a market that has delivered lacklustre performance in global terms so far in 2006? One good reason is that the past year of underperformance has left many high-quality companies on attractive valuations. The key issue to remember is that the S&P 500 index lagged its global peers at a time when corporate earnings were growing strongly, and this led to the price-to-earnings premium for American equities eroding. The fact that the valuation of the American market is moving close to parity with its major competitors creates a fertile environment for stockpickers on the hunt for superior companies at bargain prices.

The American economy continues to grow at an above-trend rate. Consumer spending remains the main driver of growth and the rising employment trend has been an undoubted fillip to GDP. The latest retail sales data proved stronger than expected, which soothed analysts’ fears that higher interest rates and rising energy costs would have begun to curb consumer spending. Nevertheless, there have been signs of downward pressure on the housing market, particularly as property valuations have become stretched relative to incomes.

The economy’s robust performance has taken many analysts by surprise and, on the earnings front, corporate results for the first quarter of 2006 have been coming in well ahead of expectations. While the pace of economic expansion will slow in 2007, earnings should continue to grow strongly in both the second and third quarters of 2006, particularly as third-quarter 2005 earnings were blown out of kilter by the hurricane season. This will provide a crucial support to the equity market.

Given the prospect of the strong economic tailwind in America gradually abating, those investors taking a bias towards companies producing robust, sustainable earnings growth will probably be rewarded. But it should also be borne in mind that, while America decelerates, other global economies are picking up rapidly. Investors can play into this disparity by backing industrials, which stand to benefit from the strength of export markets in the Far East and Europe.

The brighter outlook for industrials is underpinned by the return of pricing power. Last year rising energy and raw materials costs created a significant headwind for many of these companies, and margins came under pressure as there was almost no scope to raise prices. This year there are clear signs that companies have been able to push through higher prices for their end products, as witnessed by the widening gap between price inflation and cost inflation. For example, Caterpillar, an industrial machinery manufacturer, recently posted a strong increase in operating margins, after price increases of almost 9%.

Another strong performer in 2006 has been the energy sector, on the back of record oil prices. Refiners are benefiting from tight refining capacity globally, while coal companies have profited as the demand for their commodity has climbed. The materials sector has also offered excellent returns, particularly paper, gold and copper stocks.

Looking at those sectors that have performed less well, housebuilders have suffered due to the regular uptick in interest rates. However, we feel that valuations remain attractive and buyers are likely to become more confident once interest rates have peaked. Healthcare companies have also been lacklustre, with little evidence of strong revenue momentum.

It could be argued that the American market continues to fall between two stools. There is not enough growth to attract investors when competing against Japan and the emerging markets. Neither does America hold the promise of restructuring or significant M&A, as in Britain or Europe. The valuation argument is also less than clear-cut. The S&P 500 has for some time looked attractively priced in the context of its own history, but is still more expensive than other mature markets.

That said, we would expect some excitement on the market if investors perceive the Federal Reserve to have brought an end to monetary tightening. America is no longer the only key economy where rates are being raised. So, providing that the dollar, which has depreciated alarmingly of late, does not undermine the recently achieved “neutral” interest rate stance, the American market should draw benefit from the narrowing of rate differentials with its major competitors.

Although the jury is still out on the pace and sustainability of economic growth in America, it would be unwise to ignore the many world-class investment gems that are currently on offer in the land of plenty. So we recommend investors buy more into the companies, less into the market.