Playing it safe is good US insurance

Uncertainty about the American slowdown suggests investors should select companies that offer the prospect of medium-term growth, especially in the insurance and pharmaceuticals sectors.

The market correction of 7.4% in May proved to be quite short-lived and by July the market was again rising. This continued into the third quarter of this year, when American equities experienced their best quarterly performance since 2004. This was achieved in spite of a backdrop of mixed economic indicators, geopolitical tensions and uncertainty about the direction of interest rates.

In August, after two years of raising rates, the Federal Reserve paused in its run of monetary tightening. In maintaining its benchmark interest rate at 5.25%, the Fed acknowledged the deterioration in the housing market and its moderating effect on economic growth. However, at the September meeting, policymakers also restated their concerns about inflationary pressures.

Oil prices hit record highs during the quarter before falling to their lowest levels since February. The short-term effects on the consumer of a lower oil price have been positive, further clouding the picture of a possible consumer-led slowdown.

Towards the end of the quarter the Dow Jones Industrial Average rallied to its second-highest record level, as a rebound in consumer confidence helped to allay worries about a sharp slowdown in growth.

However, recent data suggests that the manufacturing side of the economy is weakening, with manufacturing employment falling by 39,000 and both factory orders and the ISM survey showing sharper declines than forecast. In contrast, the non-manufacturing side of the economy is performing better, and this divergence is sending conflicting messages to the Fed.

Looking at the broad employment picture, unemployment as a whole has fallen to 4.1% and payroll data indicates a rise in employment costs, with unit labour cost inflation for the business sector running at 5.2% year on year.

Company news has continued to be relatively upbeat, with third-quarter earnings coming in ahead of expectations. However, the effects of the housing downturn on the economy have remained a topic of conversation. The International Monetary Fund confirmed the arrival of the forecast housing slowdown in America during the quarter.

The Department of Commerce also reported a 6% decline in housing starts in August, bringing the figure to a three-year low. In addition, the construction of new homes fell to an annual rate of 1.66 million houses, as builders’ inventories touched record highs.

This downturn in the housing market was reflected in sluggish GDP growth, with data for the quarter pointing to an annual rate of growth of 2.6%, compared with 5.6% at the start of the year. Quoted homebuilding stocks within the S&P 500 – the five of which together account for only 0.25% – have all fallen back significantly this year and are now showing signs of bottoming. However, there are increasing signs that the weakness in the housing sector is spreading out to related areas of the economy, with sales of some consumer durables weakening.

The insurance sector, on the other hand, looks strong. As a result of better pricing following last year’s hurricanes and a lack of hurricanes this year, the sector is giving the aggregate earnings growth numbers a significant boost. The sector is set to contribute 43% to the total third-quarter forecast and, looking ahead, this is expected to rise even further, to about 50% in the final quarter of the year.

The recent mid-term elections have delivered a Democrat majority in both the House of Representatives and the Senate. This gives the pharmaceutical sector pause for thought. This is because democrats are usually keen to put pressure on pharmaceutical companies to cut prices forwidely prescribed drugs, as a way of reducing the government healthcare bills.

As a result of the political divide that now exists, it is expected that little significant legislation will pass before the next presidential election in two years’ time.

This situation has historically been good news for the stockmarket. In fact, in the year following the mid-term elections, history would suggest that the market does do well. However, this time around there is the likelihood of an economic slowdown. This has not been seen at this stage in the political cycle before, so we are entering uncharted waters.

It seems clear that we are in a slowing phase, but there is considerable debate raging over how that slowdown will manifest itself and what the eventual pace of economic growth will be into 2007.

In this type of environment it seems sensible to stick to investing in companies that offer the prospect of good medium-term growth that is generated in areas not unduly sensitive to the overall level of economic growth. There is a broad pool of corporate activity from which good companies can be selected and this results season has reaffirmed that there is still strength in many areas.