Muddling through in poor visibility

A surge in America’s GDP was mostly driven by exports. But foreign trade is likely to weaken as the dollar gains strength, and a too-close-to-call presidential race is adding more uncertainty.

Markets whooped when the Commerce Department revised annualised second quarter GDP growth statistics from 1.9% to 3.3% on August 28. Alas, the joy proved fleeting, and future prospects look dimmer. Of that 3.3% growth it turns out that net exports accounted for a full 3.1%. Without that contribution, growth would have been close to zero.

Government corporate profit numbers tell a similar story. On a year-on-year basis, American companies earned $1.369 trillion (£780 billion) in June 2007, but that figure retreated to $1.172 trillion in June 2008. Yet compare the difference in profits reaped away from home: June 2007’s foreign profits of $303 billion swelled to $383 billion – a 25% increase against an overall backdrop of an 18% decline.

That pillar of strength from abroad is beginning to crumble. “We will see the huge prop of export growth decelerate by next quarter,” predicts Keith Hembre, the chief economist at First American Funds in Minneapolis. “A broad swathe of economies have supported earnings in non-financial US equity sectors until now. The recent dollar rally also reflects more weakness abroad.”

As foreign economies spluttered this summer, the American equities market made a U-turn, away from the previous leadership in energy and commodities towards a revived interest in financials. These cross currents may not yet be fully digested into share prices, according to Dan Genter of Los Angeles-based RNC Genter Capital Management. “Major financial institutions still have access to resources from the federal governments, international capital and sovereign wealth funds,” he says. “Of course, shareholders could still be diluted in some of the more desperate situations.”

Shareholder dilution did arrive on September 7, when the American government effectively nationalised “Frannie”, the twin government-sponsored entities that fund the mortgage market. Initial reaction was positive. But again, early euphoria proved premature, as many questioned whether the move would solve the underlying credit rot.

Financials have meanwhile reported yet another gut- wrenching drop, coming in as the laggard sector at minus 93% growth in their fourth consecutive negative quarter. Keep an eye on home prices, where securitised real estate continues to undermine banks’ balance sheets. The rates of defaults and delinquencies are slightly slowing. “Could it be a head fake?” asks Jeremy Zirin, a senior US equity strategist at UBS Wealth Management Research. “We’ve certainly seen it before.” It is negative that inventory levels remain extraordinarily high, and demand drivers are scarce. Mortgage rates have barely fallen and credit is still tight. Those factors lead Zirin to conclude: “We’re quarters or even years away from a real turnaround.”

Energy, the other side of the shift in fund flows, fared best among sectors in the second quarter, gaining a robust 18% year on year. “Oil is still inflated and overspeculated, by about $30 a barrel, and the price could move in the blink of an eye,” says Ashwani Kaul, the director of research at Thomson Reuters. If unemployment rises from 6.1% to 6.5%, an ensuing recession could drive the price down further. Kaul notes, however, that energy companies should benefit if a proposed offshore drilling bill becomes law.

The oil price is down 40% from its peak, yet equities have rebounded by only 5%, which suggests something else is going on. Even as inflation jitters recede, the profit growth outlook offers so few pockets of strength. Last quarter, after energy, consumer staples and technology put in the best performances, at 15% and 14% respectively.

“Give tech its due,” Kaul urges. “IT consulting and hardware-related companies are still holding up as firms realise they can improve their efficiency through technology spending. They haven’t been cutting back where they see long run savings.” He notes a glimmer of hope in that companies’ balance sheets are still flush with cash, which they are deploying. However, since overseas sales generate 50% of technology revenues, the sector will be hit if those markets falter.

Consumer discretionary stocks put in the second worst showing, with a negative growth rate of 56%. Purchasers are tightening their belts as the pinch of shrinking home equity wears on their psyches. A classic case of the wealth effect is kicking in. Blame the auto component in large part, as it bears the brunt of high petrol prices and fuel inefficiency.

Now that energy has probably had its last hurrah, and earnings elsewhere do not promise any respite, there will be little visibility in the coming months. With no salient catalyst in sight for an equities rebound, the looming presidential election adds yet another element of uncertainty, which is the enemy of all markets. “This race represents as close a match-up as any in the past 50 years, with dramatic differences in economic platforms,” says Zirin.

A stark contrast for investors is the divide in tax policy. If Barack Obama is elected, he has indicated he will let “sunset provisions” take effect at the end of 2009, which will automatically reverse the tax relief put in place under the current administration. Genter says higher tax scales will affect both investment and economic decisions. “Obama’s tax hikes will hit those who run small businesses. Owners may not change their own lifestyles, but may be more reluctant to hire employees.” A win by John McCain, he suggests, might at least spur a relief rally, as a sign that the status quo will be preserved.

It is time to take the medicine. As equity markets trundle through the next season, Hembre’s firm has chosen to adjust its allocations, with an overweighting to fixed income. He predicts the Federal Reserve will keep interest rates on hold for some while, assuming unemployment levels hover between 6.5% and 7% next year.

Zirin agrees that risk/reward ratios for equities now are not inspiring. “We don’t see much upside or downside from here in this muddle-through period.”