Although the u.s. economy and stock markets have had several good years, the year ahead may be less robust. Growth momentum has been dropping and the risks are on the downside. That much is clear, even from an optimist’s point of view.
Economic problems in the U.S., such as the trade and fiscal deficits, heavily indebted consumers and underfunded pensions, have increased despite business expansion. Renewed growth depends on continued strong consumer spending — and there is doubt the consumer can do this.
Forecasts for economic growth this year are 3.3%-3.5%, vs 3.6% last year and 4.4% in 2004.
All this puts pressure on stock market prospects, although analysts generally are bullish for the year.
Overall corporate earnings are expected to rise about 11% this year, vs an estimated 14% last year and 24% in 2004, according to estimates by Standard & Poor’s Corp. for the S&P 500 composite index, which represents more than 80% of U.S. stock market value. S&P strategists expect a 9% total return this year from the S&P 500 index.
The question is whether these expectations are optimistic.
There is no doubt a housing price bubble exists, at least regionally. The International Monetary Fund says 18 states, accounting for 40% of U.S. gross domestic product, had housing price increases of between 20% and 50% from mid-2003 to mid-2005. Consumers are very vulnerable to a drop in housing prices. Home mortgage borrowing has soared to 8% of GDP from 3% in 2000, and household savings are a thing of the past — official estimates say there is no saving. This puts the consumer in a precarious spot should the economy slow quickly.
Productivity growth is also slowing. After gains of 5.2% in both 2003 and 2004 and almost 5% last year, the IMF expects 3% this year.
Then there is the growing federal budget deficit and the huge current account deficit in the U.S. balance of payments with the rest of the world. Hurricanes Katrina and Rita are consuming billions in extra government spending. The war against terrorism in Iraq continues to absorb additional expenditures.
The current account deficit narrowed slightly in the third-quarter of 2005, but will reach US$759 billion for the year and grow to US$805 billion in 2006, according to the IMF. Both figures equal 6% of expected GDP, a new high. It means the U.S. cannot pay its trade bills unless foreign money continues to flow into its securities markets.
The money was forthcoming last year. Contrary to expectations, enough came in to strengthen the U.S. dollar by about 8% on a trade-weighted basis. The greenback is expected to reverse direction this year once the Federal Reserve Board stops raising interest rates, a move expected in the first or second quarter. There are no immediate concerns, however, that foreign inflows will dry up to such an extent that it will cause a crisis.
Pension costs also loom as a major long-term problem. President George W. Bush was unsuccessful in his attempt to put the social security system on a sound financial basis. Companies in S&P’s composite index are underfunded by about US$500 billion for pension and retirement medical benefits. To fund this fully would excavate huge sums from corporate balance sheets and shareholders’ equity.
The one plus is inflation does not seem to be a problem. Upward pressure from high energy prices has been partially quenched by the Fed’s steady increases in short-term interest rates, which have kept the rise in consumer prices excluding food and energy (the so-called “core inflation”) to about only 2%. Economists expect overall inflation will drop. The IMF thinks it will be 2.8% in 2006, vs 3.1% in 2005.
On a sector-by-sector basis, here are the key prospects for 2006:
> Energy stocks, which had price gains of 33% last year, have even better prospects than the recent 9% earnings’ estimates suggest. Oil prices will probably remain high as long as the narrow cushion between supply and demand magnifies threats from terrorism and natural disaster.
As always, the big integrated oil stocks have long-term appeal.
> Utilities have been on a tear, placing second after energy with a 14% price gain in 2005 following a 20% gain the year before. But that reflects recovery from a period of spectacular collapses and bankruptcies. The average quality of utilities remains low.
@page_break@Three firms stand out with high five-year earnings growth projections: AES Corp., with a 17% projected growth rate; PG&E Corp., at 19%; and TXU Corp., at 14%.
Large one-year earnings gains have also been forecast for Allegheny Energy Inc., up 41%, and CenterPoint Energy Inc., up 47%.
> Consumer discretionary stocks are expected to have the best earnings’ gain this year, at 21%. Last year, prices declined 6% on a 5% drop in earnings.
This is the most diversified market sector, and includes 31 major industries. Of these, retailing has the best prospects for 2006. Among large-cap retailers, analysts say the best earnings growth will come from department store chain Kohl’s Corp., forecast to gain 43% from 2005 to 2007.
Among small-cap stocks, estimated two-year earnings growth of The Children’s Place Retail Stores is 52%, while analysts project five-year earnings growth of about 20% a year for Career Education Corp.
The outstanding industry in this sector has been homebuilding, up 24% in 2005 and 33% in 2004. Some builders are reporting slackening demand, but there is no consensus on the outlook for housing prices.
This is a large industry, with market capitalizations for 16 companies exceeding US$1 billion. The leader is D.R. Horton Inc., at US$12 billion; the average earnings forecast for this company indicates a 33% rise from 2005 to 2007. The only major stock in a downward trend is Toll Brothers Inc., which specializes in high-end housing; in November it warned of a sales drop in 2006.
> Financials, the largest industry sector in the stock market (21% of the S&P 500) may have higher earnings this year, although estimates have recently been cut sharply for some stocks in this sector, including Marsh & McLennan Cos. Inc., Everest Re Group Ltd., Allstate Insurance Co., XL Capital Ltd., CNA Financial Corp., American Express and Federal Home Loan Bank.
The major risks here are narrowing interest rate spreads and dropping credit quality. Among the huge money-centre banks, analysts expect annual earnings growth of 9%-11% for the next five years. These stocks are valued cheaply compared with Canadian banks, which have price/
book value ratios ranging from 1.3 times (J.P. Morgan Chase) to 2.6 times (Bank of New York).
In 2005, insurance stocks were top gainers, while banks and thrifts/mortgage financing stocks dropped. Overall, financial stocks gained 4% in terms of prices.
> Infotech stock prices barely rose in 2004 and managed only a 4% rise in 2005, disappointing for such a big sector. Earnings growth is slowing, reflecting the maturing of the industry (computers are now a commodity) and the dearth of breakthrough products, although Apple Computer Inc. has shown it can be done, with its iPod and associated software.
> Industrials include a diversity of industries: railways, human resources and professional services firms, construction and engineering, aerospace, office equipment and farm machinery. Most groups performed well last year, led by construction (up 35%) and human resources (up 26%). As a sector, industrials’ stock prices were unchanged in 2005, following big price gains the two previous years.
Air freight and logistics companies are becoming sector leaders. Analysts project five-year earnings growth rates of 22% a year for UTI Worldwide Inc., 19% for EGL Inc. and 14%-15% for both FedEx Corp. and United Parcel Service of America Inc.
> Materials stocks win little analyst enthusiasm, as shown by earnings estimates. Performance has dropped sharply, with prices up just 1% last year after gains of 11% and 35% the two preceding years.
But persistent strength in industrial metals prices and demand for steel, construction materials and packaging point to continued gains for these stocks. The sector includes gold mines, which are in a bull market of their own.
> Health-care stocks have been shaken by the problems of the major pharmaceutical firms. Those stocks have lost their blue-chip cachet, at least for now. In their place, health-care services and managed-care businesses have gained. Share prices in these industries rose as much as 45% last year. This enabled the sector to rise 3%.
> Telecommunications services have shrunk because of the Internet and consolidation of major wireless and landline phone companies. Sector prices dropped 6% in 2005.
> Consumer staples sector has been overshadowed by the more glamorous consumer discretionary group. The sector has lost momentum in the past three years. The sector index rose only 2% in 2005.
Drug retailing remains hot. Wine and liquor producers and distributors have been riding the consumer spending wave. Tobacco stocks regained appeal with elimination of some legal hitches. IE
Less robust year foreseen for U.S. economy, stock markets
Trade and fiscal deficits, heavy debt and underfunded pensions expected to contribute to economic problems
- By: Carlyle Dunbar
- January 30, 2006 January 30, 2006
- 10:47