The fact that financial markets should have thought otherwise, that a one off tax cut would stimulate demand, always seemed a little strange. After all, this would have been totally out of kilter with economic theory. According to the Permanent Income Hypothesis, only if an increase in income is deemed to be permanent is it likely to be spent. Consequently, all transitory increases, like for example a one-off tax rebate, will be saved. But secondly, and perhaps more importantly, the data suggests that even with almost all of the tax cuts being saved, consumer demand continues to surprise market expectations on the upside.
That this should be the case is nothing short of remarkable. For most of this year, financial markets have almost universally been discounting a consumer-led recession in the US. Indeed, the current baseline forecast from the Federal Reserve actually incorporates negative growth in the first half of 2008. Suffice it to say the outturn so far this year has been much more buoyant than this. Not only did the economy expand by 1.0% annualised in Q1, which in itself was stronger than expected, but it appears to have accelerated further in Q2. We don’t have official Q2 GDP figures at the moment. But with consumer demand increasing by 1.9% at annualised rates in the three months to May compared with 1.1% in Q1, it is inconceivable, given that consumption accounts for 70% of US GDP, that headline growth hasn’t strengthened in Q2. True, residential fixed investment spending will remain weak for some time, but given that it contracted by more than 25% at annualised rates in Q1, it is difficult to see it having such a large negative impact on growth in Q2. Don’t get us wrong, we do not believe the US economy is about to embark on a major cyclical upswing. What we are saying, however, is that there is still no evidence whatsoever to suggest that the US economy has slipped into, or is about to slip into, an outright recession.
If we are right, this has profound implications for asset allocation. Instead of heading for safety in the form of cash and index-linked bonds as some investment houses are suggesting, our recommendation would be to buy equities. This is because at current levels we believe equity markets are substantially oversold. Granted, we said the same thing a month ago, but valuations have moved even further into “buy” territory. True, they could become cheaper still in the near term, but unless we are witnessing the end of capitalism as we know it – and the end of US and UK quoted companies’ ability to grow their profits and dividends - history will show that July 2008 was a good time to buy equities.
Higher bond yields have removed some of the extreme under-valuation of US equities.
However, even with this equities look fundamentally cheap relative to bonds.
And with bond yields likely to fall as the inflation threat (in terms of the core measure) fails to materialise, the value in US equities will become even more apparent.
We recognise that earnings growth will be negative this year – but this is already in the price. We think there is scope for substantial re-rating of equities in the year ahead. In other words, and unlike the last four years, we are looking for significant multiple expansion in the year ahead.