Market commentary September 2006

The US consumer has not only supported their own economy, but the global economy, and much of the spending has been facilitated by equity release from booming house values.  After 17 consecutive interest rate increases, there are signs of severe strain in the US housing market, and consumer confidence surveys are headed down.  Should you be spooked?

The ending of the UK and Australian housing bubbles have not caused recessions, and optimists would expect, or at least hope for, the same in the US.  Moreover, the US housing market has very distinct regions, and while some are suffering badly (those where there was greatest speculative building development), much of the US is not in such bad shape.  Even so, as the next few months unfold we need to be wary of a sharper deterioration in the US housing market.

As we highlighted last month, the US stockmarket has not just been pricing in the likelihood of a slowdown or recession since the markets began to fall away in May 2006.  This process, anticipating a slowdown, actually began in 2003, with the price earnings ratio for the market going persistently lower, despite 12 consecutive quarters of double digit earnings growth.  (Last month we set out why the price earnings ratio highlights that good value in the stockmarket has been increasing in recent years.)

While an economic slowdown appears inevitable in the US, neither the extent of this nor the stockmarkets reaction seem likely to be severe.  The days of “boom and bust” cycles, fuelled by continual inflationary pressures, have long since subsided.  Now we are in a period of fairly shallow mini-cycles, where the peaks and troughs in interest rates would be regarded as Nirvana by an economist from the 1970’s.

These mini-cycles of relatively low and stable inflation could end, though none of the events that could change this picture appear either likely or imminent.  Even so, do keep an eye on the globalisation juggernaut, which has enabled inflation and interest rates to fall, and be sustained, while also achieving better growth than expected.  Protectionism is probably the biggest risk to this rosey scenario.

Looking at the UK stockmarket (the FTSE 100 index is 5980 as we write), our working assumption is that a fall down through 5500 will signal that the correction that began in May is moving into its final phase, with the result that some great opportunities could have emerged by early 2007.  On the other hand, if the index goes up through 6000 this analysis is increasingly in doubt.