What should we make of this? A key indicator, personal consumption expenditures, which measures price increases of consumer goods and services excluding food and energy, came in slightly lower than expected last week, suggesting inflation worries may be overstated.
I expect US GDP growth of 2 per cent to 2.5 per cent for 2007, slower than the 3 per cent to 4 per cent the US has been averaging over the past 2 years. US corporations, which have been experiencing double-digit earnings gains for 17 consecutive quarters, will see earnings growth taper to 5 per cent to 7 per cent. The ominous clouds overhanging the US economy have been well charted: advancing oil prices, geopolitical unrest in the Middle East, the deepening housing slump in some regions of the US and continued debate over the Federal Reserve’s course of action on monetary policy. Signs of economic slowdown are manifest in higher business inventories, a significant drop in durable goods orders and below-par capital expenditures.
Anemic growth will prompt the Fed to cut core interest rates by 50 basis points in two separate actions to 4.75 per cent over the course of 2007. I believe the US economy is in the midst of a normal mid-late slowing in the business cycle, but not severe enough to engender a recession unless the Fed overreacts to inflation concerns.
Where should investors in US securities place their bets in this scenario? I favour defensive growth sectors such as health care and consumer staples. Segments within the financials sector that could benefit from very active capital markets and lower interest rates hold some appeal. Price/earnings multiples on high-quality, cash-generating stable growers are at some of the lowest levels since the early-1990s. I recommend investors steer clear of cyclicals and industrials in the US equities market. Spreads between riskier securities and US Treasuries are at unsustainable lows in my view, leading to an upswing in the risk premiums investors will demand for holding riskier assets.
I anticipate US equity market returns in the low single digits for 2007 and the recent uptrend in market volatility to continue. Despite the see-sawing between higher inflation and economic dampening, US investment fundamentals are solid going into the balance of 2007, relative to historical norms. US corporate balance sheets are sound, M&A activity is ebullient and interest rates are at attractively low historical levels.
Horacio Valeiras, managing director and chief investment officer at Nicholas-Applegate Capital Management.
