BlackRock - Investment Commentary 20.07.09
Following a month-long correction, which appeared to be induced more by profittaking than by any reversal in economic trends, equities rallied strongly last week to approach their previous highs. The Dow Jones Industrial Average rose 7.3% to 8,744, the S&P 500 Index advanced 7% to 940 and the Nasdaq Composite added 7.4% to close the week at 1,887. US earnings surprised on the upside last week, building on the string of supportive economic data seen over the past few months. As a result, the market averages managed to erase much of the losses from the prior several weeks' correction. Equities held up even as the flight-to-safety premium in Treasury securities staged a small rebound.
So far, second quarter earnings look pretty good. Although it is still early, of the few firms that are reporting, more than three-quarters are either hitting or beating estimates, usually via aggressive cost-cutting. Year-on-year revenue growth remains weak and currency remains a headwind. Guidance going forward is increased from the prior quarter and is reasonably good and, as a result, third-quarter bottom-up estimate numbers are starting to move up. We give corporations high marks for cutting costs. Once sequential revenue growth returns, probably in the fourth quarter, margins should once again start to expand.
We find that many market participants are still skeptical and appear convinced that there remain significant downside risks from continued deleveraging by an overstretched US consumer. Given the depth and nature of the current recession, and the underlying structural headwinds (i.e., deleveraging), skepticism in the recovery is particularly high. Investors are likely to remain sensitive to changes in the economic data and profit figures, and the debate about the sustainability of the recovery will continue for some time. However, we believe a lot of investors will be induced, through positive economic and earnings news, to join the recovery story in the coming months. It will be critical for the equity market that policy remains stimulative and that earnings reports are decent enough as investors wait for better news, and we think that will be the case.
We have been in, and perhaps will see some more of, a critical testing phase-that is, whether reflationary efforts will translate into a recovery process around the world. Currently, there remains an intense standoff between reflationary forces and debt deflation pressures, a theme we have argued since the beginning of the year and which, at the moment, has created somewhat of a stalemate in risk assets. We continue to believe that reflationary policies will ultimately win out, allowing global equity prices to move higher. At this juncture, the US equity market is back to levels consistent with a bad recession, though it appears prices have not yet factored in much of an economic recovery. Our bet is that the US economy will enter into a cyclical recovery phase later this year and, if that is the case, share prices will need to move somewhat higher to reflect this.
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