Alan McChesney: America will set the tone for 2010

Opinion

The customary year-end break of the past few weeks will have given many investors the opportunity to take stock as they plan for what lies ahead.

While last year wasn't as grim as many would have predicted, it remains a year many would rather put behind them.

Some, having sat on the sidelines while global sharemarkets staged a remarkable mid-year recovery, may be wondering if they've missed the boat. Others who pounced may be wondering if they should redistribute their portfolio more conservatively.

It is no wonder there are such diverse opinions about the investment outlook in light of the severity of 2008's near-death experience. That such an intense rally should follow so quickly after an apocalyptic meltdown may seem baffling when we consider that the global economic recovery still remains fragile.

While many economic indicators are looking slightly rosier, with some countries such as China and Australia already returning to positive growth, unemployment continues to worsen and governments in developed economies like New Zealand will have to wear budget deficits that may well be a legacy for a generation or two to come.

While the 50 per cent-plus recovery off March lows may appear impressive, there is more than a suggestion that markets have run ahead of themselves. And let's not lose sight of the fact that a 50 per cent loss followed by a 50 per cent gain only recoups half the loss.

It is unlikely investors will see a full recovery of their loss this year. There remain question marks over the quality of the stocks that have driven the equity market rally.

There are also serious doubts over the current high valuation of stocks that have led the rally, which suggests that these stocks may be vulnerable to a correction that will impact significantly on the indexes.

We should not expect a strong economic recovery, but there are a number of good reasons for canny investors to seek more sharemarket exposure.

In this, we need to cast our eyes to the US. That China is now the second biggest global economy - with tremendous growth potential for any savvy New Zealand investor - is irrelevant as long as the US remains the focal point in the news, because that is what ultimately determines sentiment.

First, cash levels in the US remain high, a reflection that capital preservation is still foremost in many retail investors' minds. In time this risk aversion will decline. And as we all know, markets move before the numbers show it.

Secondly, global equity markets appear to have finally moved into a period of stabilisation, halting the headlong rush higher over the past nine months. In doing so, they have also avoided the big correction that many had been anticipating.

Thirdly, US businesses in general are in particularly good health, primarily because they have not carried significant debt into the maelstrom. Low interest rates and ample liquidity in the new millennium gave businesses the opportunity to aggressively restructure their borrowings and reduce debt, having been burnt by over-investment decades earlier.

Having finally manoeuvred themselves into a much stronger balance sheet position, these companies were reluctant to chase the cheap money that was around before 2007.

This will be 2010's potential big surprise: stronger than expected profits in the US. Their businesses have used the sharp downturn to slash costs, especially labour, and are now running lean and hungry enterprises with strong cash flows where any increase in revenues will be directly translated to the profit line.

While many commentators have expressed the view that this cost-cutting will have a one-off short-term benefit, they miss one critical point. Businesses will be able to hold off increasing overheads for quite some time, adding staff only when it is absolutely necessary to do so. This will lead to a very large labour productivity gain.

There may be validity to the view that the S&P500 equity index is now fully valued, but this misses several key points.

First, as mentioned earlier, the rally in the valuation of the overall index has been driven by stocks that are now clearly overvalued. In the meantime there are many quality defensive stocks, such as Coca Cola and Procter & Gamble, that have not taken part materially over the past nine months and remain particularly attractive on any valuation basis.

It is this latter group of defensive stocks that should also be beneficiaries of the profit boom. Not only have they cut costs, but many of these businesses derive a sizeable portion of their revenues from the emerging markets where the economic recovery is now well under way.

Higher profits, stronger cash flows and the ability to access cheap credit should lead to an economy that is driven by a significant uplift in corporate capital expenditure through increased merger and acquisition activity, renewed capital investment on R&D, and new productive capacity in the form of new plant and more jobs.

The second part of the US recovery should come from the export sector, where the low US dollar is putting US companies in a very competitive position relative to the rest of the world.

In this, it is ironic that for the next global economic cycle, it will be the US that will be relying on consumers from the rest of the world to buy its goods, instead of vice versa.

* Alan McChesney is principal of investment firm New Zealand Assets Management.