-
Second, we feel that the continued expansion in the economy will put the labour market under more pressure. The trend of wage growth is already upwards and has been so for three years. Also, slower GDP growth combined with faster wage growth spells faster growth for unit labour costs - wage growth adjusted for productivity growth. Unit labour costs are a key influence on core inflation.
-
Third, the chart illustrates the point that Bernanke and Co have made several times, namely that a slowdown in the economy is required to achieve a growth rate that is consistent with the Fed’s recently revised (and lowered) estimate for potential output. An economy in ‘transition’ does not necessarily warrant cutting interest rates. We expect GDP growth of 2.7 percent in 2007. That represents a modest slowdown after the 3.3 percent GDP growth that is likely this year.
-
Fourth, the slide in the dollar stimulates aggregate demand. By enhancing the international competitiveness of the US economy, domestic producers gain at the expense of foreign producers. Domestic output increases along with the demand for more jobs. Job creation boosts consumer spending, profitability, investment and so on.
-
Fifth, according to the OECD, the US output gap is positive, meaning that the economy is operating beyond the limits of its capacity to grow without inducing inflationary pressure. Therefore, any stimulus, be it a cut in rates or a weaker dollar, is potentially inflationary.
-
The bond market has been tolerant of the Fed, whose intention has been only to restore interest rates to levels judged appropriate to sustaining non-inflationary growth. But if core inflation remains stubbornly above the 1 to 2 percent comfort zone, the Fed will move on and, since interest rates typically rise by more than expected in a maturing phase of the cycle, the risk is that the bond market proves to be less accommodating of the Fed than it has been so far.
-
On the equity market, we think earnings will grow by 10 percent next year following the 14 to 15 percent growth that is likely this year. The weaker dollar should help on two fronts; on ‘translation’, since nearly 30 percent of the sales for the S&P 500 is derived overseas, and on ‘transaction’ since it stimulates domestic output.
-
The expected slowdown in earnings growth for next year needn’t mean that the earnings surprises can’t still be on the upside. As the chart shows, the trend in earnings growth for the S&P 500 has been downward since peaking in the latter stages of 2003, yet earnings growth has exceeded expectations consistently since.
-
The bottom line is that we expect the equity market to remain earnings driven and supported by a favourable valuation. By the end of 2007, if not before, we think the S&P 500 will be challenging its former peak level of 1527 set in March 2000.
* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.