“Year-to-date, the S&P 500 is up around 10% to 31st July 2012, which is about in line with our earnings growth expectations for the year. Earlier this year, liquidity measures from the European Central Bank helped fuel a rapid, and what we felt was a too quick, improvement in equity returns. Since then macro worries have again taken over, set against a backdrop of slower economic growth with many US investors wondering how a 10% return can feel so bad. Following a correction in investor expectations - post downward GDP and earnings revisions, we are now in a period where companies could have upside surprise again. However, given that the market has already discounted 10% earnings growth, further upside would require some level of multiple expansion, which may be difficult due to the situation in Europe and with worries about the US fiscal cliff, leaving us cautiously optimistic about the remainder of the year.
“Leading indicators are finally finding a bottom and while economic growth is slower than we expected earlier this year, the US is still growing in the 1.5-2.5% range. Now that expectations have fallen, barring a recession - which we do not expect - the sentiment bar appears to be low enough. We believe slower economic growth will likely drive more QE in the US, as the Fed continues to articulate its focus on the dual mandate – balancing growth and inflation. If additional QE occurs, it is likely to be large and could make us moderately more optimistic about the outlook for the remainder of the year.
“Political risks remain – but why not kick the can down the road again? We are hopeful that as clarity improves around the political situation in the US, that we could set the stage for another leg up in the market as investors get comfortable that 2013 will be another year of moderate earnings growth.
“US corporations are well positioned from both an earnings and cash point of view, even when including the financial sector. While government balance sheets (both Federal and Municipal) are clearly challenged, the long-term demographic and growth profiles of the US makes it better positioned to deal with a fiscal drag, particularly when compared to other developed markets. We think the base case for EPS growth in the US is still around +5% for 2013.
“Valuations on this year are not overly stretched at ~13X compared to an average historical level of ~14X. We view this valuation as attractive relative to other developed markets, where growth prospects are clearly more challenged. The US is trading at a premium to most other equity markets but also has more supportive secular growth drivers (demographics, innovation, and productivity). We believe the higher quality of the US market supports a higher multiple – you get what you pay for. We are still able to find companies where growth expectations are being underestimated and where valuations are below long-term growth potential, another bottom-up sign that markets are not overvalued on a long-term basis.
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