Recent strength can be attributed to a turnaround in sentiment, resulting from retreating oil prices and signs that interest rates may have peaked, despite the view of some commentators that the Federal Reserve is on hold before starting to tighten again.
The coming year may see a gradual slowdown in economic growth, although a recession is unlikely as the Fed looks set to achieve a soft landing. Key is the resilience of the consumer in the face of a cooling economy, although recent evidence paints an upbeat picture. While the continued slowdown in the housing market may prove troublesome for the consumer and remains the biggest risk, we expect lower mortgage rates (as a result of lower interest rates next year) and fuel bills (due to declining oil prices) to help offset most of the housing market woes.
Inflation sentiment, a key driver of interest rates fears for the best part of the last year, is also improving, with oil prices having retreated considerably of late. Oil inventories have reached an eight-year high and the plentiful supply has led OPEC to cut its production quota. Alongside this commodity prices have also seen a turnaround, adding to the easing of inflationary pressures.
Companies remain in good health and while earnings growth is expected to slow gradually from here, we expect the slowdown to be an orderly one. M&A activity also remains supportive, with 2006 set to be a record year. Private equity firms have been very active during the last few months. During the second quarter of the year private equity companies were able to raise $47bn, yet they only put $6.7bn to work, suggesting that the remainder of the year could see significant market-supportive corporate actions. There has been an acceleration in the corporate sector’s attempts to return capital to shareholders and we expect further support to be forthcoming.
In light of this, and given the benign economic backdrop and the potential for monetary easing in 2007, we are very constructive on the outlook for the market. In expectation of a soft landing the market’s risk appetite is likely to increase.
Finally, the market appears attractively valued with equities looking cheap relative to bonds. It is currently on its lowest price/earnings ratio since 1994, at which time there began a four year period of multiple expansion. Based on this, we feel that there is the opportunity of a re-rating once again, albeit with the possibility of a short-term consolidation.
Tracey Lander, manager of the Old Mutual Pooled Pension Fund, Old Mutual Asset Managers.
