09/10/06
US slowdown spreading out slowly
Global equity markets have entered a transition phase. Uncertainty is growing as investors try to assess the extent and pace of the slowdown expected in the US economy into 2007. Events there will drive the fortunes of other international markets.
In global terms, we have reached a stage where central banks are taking steps to withdraw the ample liquidity they made available at the end of the equity bear market. Higher interest rates around the world have combined with spiralling oil prices to slow economic growth. It has rapidly become the consensus view that a significant US economic slowdown looks likely over the next 12 months. Early indications have been seen in housing and parts of the retail sector, with this weakness starting to ripple out into manufacturing and services. However, a recession is still unlikely as the corporate sector is in much better shape than at the peaks of previous cycles.
How are investors in other markets assessing the situation in the States? The UK stock market has a large number of firms with significant operations in the US. As the inventory cycle there starts to unwind, UK investors are starting to quantify its impact on the trading statements of companies. While the full impact is not likely to be seen before the end of the year, the early indications are actually quite encouraging. Share prices of UK stocks with exposure to the US consumer or to the dollar have already adjusted to the worsening US newsflow. Building materials companies like Wolseley, leisure stocks such as Carnival, and aerospace stocks including Smiths Group and BAE Systems, have all seen their ratings contract sharply. However, it is noticeable that the share prices of equivalent US stocks, such as the retailer Home Depot, or some of the housebuilders, appear to be trying to bottom out. Hence, investors are starting to search for companies with strong fundamentals that can recover.
A slowdown in the US presents a dilemma for Asian investors. On one hand, Asia is very sensitive to US interest rates, so confirmation that these have reached a peak would be supportive. However, as US economic growth slows, it will have a negative impact on the demand for Asian exports. This would prove damaging for companies such as Li & Fung, an outsourcing business which US companies use to source Chinese production for them. Li & Fung recently acquired distributors in the US and the company is therefore vulnerable to any major slowdown.
The fall in US demand for Asian exports is not always straightforward to assess. It is no surprise that Japanese shippers are at risk from a US slowdown, and certain stocks in this sector have already sold off. However, the Japanese auto sector faces an interesting situation. As US consumers demand more fuel efficient cars, so Japanese companies are taking significant market share from the big three US producers, who are planning sizeable production cuts later this year. In contrast, many Japanese firms are operating at full capacity in their US plants. Indeed, in the short term, Toyota and Honda have been forced to export more cars from Japan to meet demand. Almost half of the export volume growth in July from Japan to the US was attributable to autos. The key issues for such companies therefore will not only be the extent of the slowdown in US auto demand over the coming months, but also its composition between importers and domestic producers.
It is not a surprise that concerns over a slowdown in the US have cast a shadow and dampened the enthusiasm of investors. In some cases though it would appear that too much bad news has been priced in. Using our Focus on Change approach, we have considered whether some stocks have been oversold. The technology sector is classically considered to be highly cyclical, and dependent to a large part on consumer and corporate demand from the States. Our fund managers have been taking advantage of recent weakness to buy Chi Mei Optoelectronics, a maker of LCD televisions (flat screens), which are a classically cyclical product. We believe that Chi Mei Optoelectronics will benefit as competitors reduce their capex plans.
The US slowdown will continue to loom over global equity markets well into 2007. Some companies have direct operations in the States, others will see knock-on effects through third parties. The impact of US weakness is not always easy to assess, requiring in-depth analysis across individual sectors depending on their competitive advantage. The key issue for investors will be to buy attractive assets when they consider that sufficient of the bad news has been priced in. Some examples have already been found, but in general our House View would warn of further market volatility before the extent and nature of the US cycle is finally clear.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Fund Strategy on 9 October
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