Friday, December 24, 2010

2011 US Market Outlook

KEY POINTS:
* With the consensus expecting 2.8% full-year growth for the US economy in 2010, our earlier estimates (of 3.7% growth) look a tad high.
* Nevertheless, we correctly identified the drivers for economic growth in 2010.
* For 2011, we expect investment to be a less significant contributor, while consumption should be a larger contributor to GDP growth.
* While consumer sentiment remains poor, retail sales have rebounded and the credit cycle appears to be turning, positive indications for US consumption.
* We expect 3% full-year growth in 2011, driven by PCE, and to a lesser extent, gross private domestic investment.
* Following the end of recessions, profit margins usually rebound, and this has been the case following the end of the 2008-2009 recession.
* While the recovery in profit margins has driven earnings growth for 2010, we expect rising revenue in 2011 and 2012 to drive corporate earnings.
* As of 20 December 2010, we think that the US equity market can return in excess of 30% by the end of 2012, and we have thus maintained a 4.0 star “very attractive” rating on the US market.

AN ASSESSMENT OF OUR PREVIOUS FORECAST
At the end of 2009, we forecast that the US economy would grow by 3.7% in 2010 (see “US: 2010 growth at 3.7%”), a growth rate far quicker than what the consensus had been expecting at that time. Our faster-than-expected growth rate was predicated on strength in gross domestic private investment, fuelled by inventory restocking, which we highlighted as the key driver of US economic growth. We also expected consumption to be a less important driver of growth, with a weak housing market and difficult job situation expected to weigh on consumer sentiment.

While the Bureau of Economic Analysis will only release data on full-year US GDP growth early in 2011, current consensus estimates are possibly more accurate than at the beginning of the year, and the market now expects 2.8% full-year growth for 2010 (based on Bloomberg consensus estimates as of 21 December 2010, 69 industry experts expect growth of between 2.4% and 2.9%).

Our expectations of investment-driven growth did in fact play out in 2010, with gross private domestic investment currently the largest contributor to US economic growth for the first 3Q 10, exceeding that of consumption or even exports. However, the contribution from gross domestic private investment was still slightly below our forecasts, while strong imports have weighed on overall GDP growth in 2010.

EXPECT CONSUMPTION-DRIVEN GROWTH IN 2011
Having led for most of 2010, investment to take a backseat in 2011
While 2010 has been a year of business investment, 2011 could be the year when the US consumer finally begins to exert itself again. For 2011, we still expect a positive contribution from gross private domestic investment, but we believe that the key growth driver for US growth will likely come from personal consumption expenditures. Some experts have previously criticised US growth as “low-quality”, driven mainly by inventory restocking activity. We would argue that the inventory restocking process is a necessary feature of the recent US economic recovery, given how low inventory levels fell to in late 2008 as economic activity almost came to a standstill. After five consecutive quarters of positive inventory restocking (since 3Q 09), we would expect restocking activity to peter out going into 2H 2011, and will be a substantially smaller contributor to GDP in 2011. Business spending has recovered strongly (evidenced by strength in gross private domestic investment, which still continues to see a negative contribution from the residential component), but we think that growth in 2011 will be driven by a revival of the US consumer.

Positive indications from US consumers, credit cycle turning
4Q 10 has already thrown up some indication of the strength in recovery of US consumption. Retail sales numbers have come in strongly, leading the measure almost back to historical highs (even if one excludes automobile sales, see Chart 1). Consumer credit also appears to be turning around, albeit slowly (see Chart 2). US consumers embarked on a deleveraging spree in late 2008, resulting in 23 straight months of credit contraction, the longest on record. The downward trend appears to have turned in late 2010, with September and October 2010 both seeing a small positive monthly gain. While this represents only two data points, the turnaround in trend is encouraging and we believe that the end of the consumer deleveraging cycle may be near.

Chart 1: Retail sales almost back to historical highs
US Retail Sales

Chart 2: Credit cycle turning around
US Consumer Credit

Marginal contribution from PCE in 2010, measure to gain in 2011 as consumer confidence picks up
We do not deny that deep structural problems remain in the US housing market, and it may take years for excess housing inventory to be weeded out. On a more positive note, the job market situation has turned less dire in recent months with nonfarm payrolls surprising on the upside, and we may see more job creation as US corporations hire personnel to man newly-created capacity.

Chart 3: PCE's contribution set to increase
Contributions To US GDP Growth

Despite these troubled areas of the US economy, PCE (personal consumption expenditures) have gained for five straight quarters, in line with the US economic recovery. However, the contribution of the PCE component has been less significant, with the measures contributing between 0.7% and 2% to overall growth (see Chart 3). This suggests a spluttering recovery in US consumption, highlighting an uncertain consumer (the Conference Board Consumer Confidence index still remains at levels consistent with past recessions). Given that confidence remains low at present, there remains much scope for sentiment to improve, which could have a multiplier effect on consumer spending. A large improvement in the job market could be a key driver of consumer sentiment in the medium term, and investors may wish to watch the monthly US nonfarm payroll data as a catalyst for a turnaround in consumer sentiment.

3% GROWTH EXPECTED IN 2011
For 2011, we expect 3% full-year GDP growth, driven by PCE (+1.9%) and gross private domestic investment (+1.3%). We expect moderation in export and import growth, and we forecast a 0.7% deduction in 2011 GDP by net exports. Nevertheless, our estimate is still more bullish than the current consensus estimate of 2.6% (based on Bloomberg consensus data, as of 21 December 2010), and should quarter-on-quarter GDP figures surprise on the upside, this may provide some impetus for the stock market’s ascent.
Contributions to Percent Change in Real GDP Growth

PROFIT MARGINS HAVE EXPANDED, REVENUE GROWTH TO DRIVE PROFITS IN 2011
With the onset of a recession, demand declines quicker than companies are able to slash operating costs, resulting in a sharp drop in profit margins (see Chart 4). Given the lowered level of demand during a recession, companies operate with excess capacity, resulting in lower profit margins. Many companies then embark on cost-cutting measures to reduce overheads and capacity, so when demand inches up following the end of a recession, profit margins (and profits) can spike due to the lowered cost structure.

Chart 4: Profit margins have rebounded
S&P 500 Profit Margin

While 2010’s strong earnings growth for US companies has largely come from cost-cutting measures undertaken during the recession, consensus estimates are for a record-high level of revenue in 2011 (see Chart 5), with further sales growth in 2012. Current estimates are for revenue growth of 5.9% in 2011 and 6% in 2012, rates which are not overly-optimistic, considering that S&P 500 companies previously grew sales at an average rate of 8.1% a year from 2003 to 2007, following the 2001 recession.

Chart 5: Sales expected to recover
S&P 500 Revenue

The combination of a lowered cost structure as well as rising sales should see US companies easily achieve the estimated 13.6% earnings growth for 2011 and a further 13.2% growth in 2012. Profit margins have already rebounded, and with a further recovery in revenue, profit growth is likely to be healthy next year.

Based on the S&P 500 earnings-per-share estimates for 2011 and 2012, the US market currently trades at just 12.8X 2011 earnings, and looks even more attractive at forward PE ratio of just 11.3X based on 2012 estimated earnings. We think that the US market should be trading at 15X PE by the end of 2012, which translates to an index target of 1648.95 for the S&P 500, representing 32.2% upside (as of 20 December 2010). With an attractive level of upside potential in the US equity market coupled with a positive economic growth outlook, we maintain a 4.0 star “very attractive” rating on US equities.

Source: FundSuperMart.
Author : iFAST Research Team

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