With the Dow Jones Industrial Average breaking into record territory this week, equity markets have had a strong rally since July. The turmoil that spread through global markets from May has given way to greater investor confidence that the US is facing a soft rather than hard economic landing and that the US Federal Reserve has finished raising interest rates. But how long will the run continue?
Henry McVey (above), chief US investment strategist for Morgan Stanley, is a highly respected market watcher. He joined Morgan Stanley in 1993 as an analyst and moved into the US strategy group in January 2004. His insights are closely watched and tracked by US investors. Mr McVey answers your questions on the market below.
(Morgan Stanley may have positions in markets discussed)
Are you concerned that the top of the US interest rate cycle could lead to a sell-off in US assets as investors begin to focus on the possibility of a weaker dollar?
Paul Caile, Norway
Henry McVey: I do not. The big issue with the dollar is not the yen or the euro. It is Asia. That is where the issue lies. To fix America’s problems, there have to be some major currency shifts out of China and its peers. We do not see that in the near-term. So, my view is that the dollar can fall relative to the yen and euro, but I do not see a major correction unless (US Treasury secretary) Paulson ‘fixes’ the mismatch in Asia. Separately, I still view the dollar as the global currency of choice, which I think helps to provide support too.
Is the energy play over? What’s your longer-term view on the commodity play? Which sectors do you recommend for the next two years? And globally, which markets are the most attractive?
Riaz Khandwala, London, UK
Henry McVey: Energy is not “over,” but it is taking a pause. Rate of change matters with cyclical stocks. So, as long as revisions to earnings and GDP fall, the stocks will struggle. We think that this period could last through the end of 2006. Longer-term, we are bullish. There is no clear substitute in the US, and what is occurring in China is both awesome and scary.
I do not see China adopting major reforms that lead to reduced consumption in the near future. Within energy, focus on stocks with solid production growth because that is a scarce commodity. Also, companies with exposure to oil services and offshore infrastructure.
What is your opinion about the relative attractiveness of US equity vs US bonds currently, with reference to the earnings yield/bond rate ratio, amongst others?
Gerrit Smit, Wimbledon, London
Henry McVey: We think that equity yield on stocks of 6.3 per cent versus bonds at 4.6 per cent skews the risk-reward towards equities. For equities to have an earnings yield equal to bonds, our S&P 500 earnings forecast for 2006 would need to fall to $62 from $85. This seems unlikely with one quarter to go.
However, we are not major bond bears for three reasons.
First, demographics are creating enhanced demand for yield from retirees.
Second, many investors in Asia, including the governments, are major savers, and the US bond market provides yields that are superior to what their home countries are offering.
Finally, given all that is going on in global pension reform, there is increased demand for bonds.
What sectors would you recommend and which ones should I avoid?
Tom Stoko, London, UK
Henry McVey: We favour financials right now. In particular, brokerage and insurance stocks. Almost 50 per cent of the incremental earnings in the S&P 500 will come from financials in the next two quarters, and we believe that there is actually upside to this forecast. We also like healthcare, including both pharmaceutical and biotechnology stocks. We also favour staples, including global beverage and tobacco names. We are more cautious on early stage cyclical companies, including materials.
What do you think of the big cap vs small cap debate?
Miranda Green, US
Henry McVey: There has been a lot written on this topic. We believe that May was an important month for a leadership change. From a sector perspective, our call is that financials, healthcare and parts of technology will now lead versus energy and materials. On the capitalisation front, we think that investors want to walk, not run, up the cap curve. Big cap stocks are cheaper, but there is still a lot of liquidity out there. This liquidity may help to ensure that small caps do not fade as much as some of the bears think. So, bottom line, buy bigger cap stocks, but do not get so concentrated that you miss some of the smaller, more dynamic growth stories.
Longer-term, our work shows that $30bn-$50bn market capitalisation stocks are the place to be. They generally have enough size to compete globally, but they are not so big that they trip all over themselves.
Do you think Fed chief Ben Bernanke has done a good job? Do you think we have finally seen the top of the interest rate cycle.
Jonathan Gillard, London, UK
Henry McVey: I think that Ben Bernanke is gaining credibility. Many investors felt that he was consistently ‘flip-flopping’ on his interest rate and inflation forecasts, but I think the recent headline inflation and job growth data underscore that he was right to pause. Investors do not like uncertainty, so anything Mr Bernanke can do to deliver a clear message is a major positive for the markets.
I am in the camp that the Fed is out of the picture for two reasons. First, he did ‘break’ the back of the housing market, which was key to minimise speculation. Second, he helped to deflate commodity prices. The latter will be more difficult because we live in a global economy, and demand trends out of Asia, China in particular, remain robust.
Given the fall-off in these areas, I would look for headline inflation to go below core inflation in the next six months. If we are right, this move should give the Fed room to pause or maybe even trim rates in 2007.
Given what has happened to Amaranth (the stricken hedge fund), do you think other hedge funds have been caught by the turn in commodity prices?
Harvey Goldberg, US
Henry McVey: I think that there will always be financial intermediaries, including brokerage companies and hedge funds, that take bets that are too concentrated. We will see this movie again in the investment business, particularly if the commodity markets stay volatile. However, the message for investors is to focus on companies and funds that offer diversification. Long-term returns are usually best generated by finding undervalued stocks and being patient.
What are you main reasons to be worried about the outlook for the US market?
Jamie Fulton, Scotland
Henry McVey: I am actually constructive on the US market. Rates are low, equity valuations appear reasonable and growth should be solid, albeit unspectacular next year. Also, credit conditions are benign, which is important for stocks, given how big financial services is in the American economy.
Risks to our forecast are that housing acts a negative catalyst on growth. However, that view now seems to be in the consensus. Another risk is that we do not get any multiple expansion in equities. You can make money in stocks three ways: dividend yield, earnings growth, and multiple expansion. The past few years we have had wonderful earnings but the multiple has contracted 25 per cent.
Looking ahead, however, earnings growth will be more muted, so we will need multiple expansion to achieve a solid return in equities. We think that this can happen for several reasons. First, it is unusual to have four years of multiple contraction in a row. Put another way, we are looking for some mean reversion in this area.
Second, the earnings mix shift is moving towards businesses that typically demonstrate premium valuations, including technology, healthcare and industrials. This should be quite a change from the heavy influence lower multiple sectors like energy and financials (which will account for nearly 50 per cent of S&P 500 incremental earnings growth in 2H06!).
What proportion of the world rally we are seeing is down to the optimism in interest rates seen in the US, especially if the rally seen in the UK is said to be more related to M&A upsurges? What is the major factor on a world scale?
Ishtiaq Hussain, Glasgow, Scotland
Henry McVey: I think that declining headline inflation, which we expect to fall to 2.3 per cent from over 4 per cent this summer, is driving the bond market. Nine out of the last 10 times after the Fed stopped raising rates, bonds rallied. So, the current move is actually normal. With inflation falling, it forces investors to choose among financial assets. The earnings yield on stocks is now 6.3 per cent (earnings divided by price) versus 4.6 per cent for bonds, so investors are likely to favour equities at current levels. That is what is driving the change in equity markets.
M&A is also important. The arbitrage we see is that many of the larger capitalisation companies trade at valuation discounts to where private equity deals are being completed in Europe, Asia, and the US. This acts as floor on valuation.
Do you think the housing slowdown in the US will continue into a major correction and see an overall recession in the US in 2007, as predicted by other analysts?
Andrew Law, Shanghai, China
Henry McVey: I do not see a 2007 recession. We recently surveyed 100 CFOs and capital expenditure growth is expected to be nearly 5 per cent next year. Companies still have plenty of cash on their balance sheets, and I think that restructuring in Japan and Europe will help to offset slower US consumption. More important, I think that today’s upward revisions to past job growth shows that the economy is healthy, despite weaker jobs for this month.
Also, remember that 70 per cent of America’s net worth is concentrated in 10 per cent of Americans, who earn 45 per cent of the country’s income. Within this high end segment, earnings and wealth are robust, which should maintain solid consumption.
Within the housing market, I do think that we will see negative home price appreciation, particularly on the coastal regions. Every time house price appreciation has reached 20 per cent on the coastal areas, which is what we saw last year, we have. This will put pressure on commodities and should lead to slower growth overall. However, I think we would need to see a supply shock (for example, oil at $90 or a terrorist act) to create a recession next year.
Some say the markets have been manipulated and don’t trust the rally. Do you think we’ll see a low before December?
Henry McVey: The rally that started in July has been on light volume. This is true. However, I think many investors have been in disbelief. Our view is that equities will remain the asset class of choice. Headline inflation is coming down, which is key to stock market valuations. Also, bonds appear expensive at the same time that real estate and commodity prices are falling. So, my view is that the markets are not being manipulated.
In addition, many funds have taken so a negative stance on global growth that they have been forced to ‘chase’ this rally. My only other thought is that, by and large, regulators do a sound job of preventing market manipulation.
Where are we in the credit cycle?
K.W, Washington DC, US
Henry McVey: We are at the bottom – it can’t get much better. Both consumer and corporate debt credit is pristine. Looking ahead, I would stay focused on two areas. First is the sub-prime housing market. Credit extension in this area has been outsized, and with home ownership at such high levels, there are bound to be some issues when the economy turns down.
Second, private equity firms are using more and more debt to complete bigger and bigger transactions. While not a concern today, an economic downturn will reveal some unsettling trends in this area, particularly in the high yield or “junk” markets.
If I had to guess today, my best bet would be that these issues start to emerge in 2008.
Is a recession likely and will there be a bear market in 2007? Do you think earnings will slide?
Nasir Walker, London, UK
Henry McVey: I do not think a recession is likely in 2007. Growth is slowing, not collapsing. We see S&P 500 earnings growth around 5-7 per cent next year. The key variable will be credit, because financial services companies account for such a big portion of the profit pool. However, corporate America still has 10 per cent of its assets in cash, which should serve as an important credit buffer. I do, however, acknowledge that the consumer side is more risky, and sustained employment growth is important. It may be different this time, but a housing-driven recession has never occurred without employment growth turning negative, which is not our base view for next year.
Our bigger picture thought is that we are in the latter stages of the equity market rally. In fact, the recent run in stocks is the second longest in history without a 10 per cent correction. So, my guess is that we are probably in the seventh inning of this bull market.
Do you have an opinion on oil versus housing as it effects consumer psyche going into the all-important Christmas selling season? As manufacturers are in their ‘build’ period now, do you think consumers will spend or save?
Doug Godine, Baltimore, US
Henry McVey: I think gas prices are critical. The fall-off in gas from $3.00 to $2.50 should add $65bn to US consumption. So, while I am not expecting robust consumer spending, I do think it will beat lowered expectations. In terms of preferences, my view is that retail outperforms housing related purchases. Of America’s net worth, 42 per cent is now tied up in real estate, which is almost 12 points above the long-term average. The rate of change will continue to be negative in this area for quite some time.