U.S. equities: Key themes for 2010

In 2010, we will see additional stimulus being put to work and a continued accommodative stance by the U.S. Federal Reserve (the Fed).

In 2008/2009 the world witnessed a near collapse of the global economy, as bank lending and global trade screeched to a halt. The response was a coordinated effort to help reflate a floundering global economy through record-low interest rates and unparalleled government stimulus. As well, transformative changes took place in the Western capitalistic structure, as governments came to the rescue of multinational banks and automakers, putting aside philosophical idealism for pragmatic realism.

Fortunately, the actions taken by policy officials helped rescue the global economy from the next Great Depression, and, possibly, put the economy back on track for a recovery. Following are some of the key U.S. themes for 2010 and beyond.

Debt, debt and more debt

One of the major consequences of the coordinated plan to revive global economic growth is a massive increase in public debt. With the financial and automotive bailouts and fiscal stimulus programs, the U.S. will record an estimated $1.6 trillion deficit this year, or nearly 10% of gross domestic product (GDP). According to the International Monetary Fund, the U.S. total public debt to GDP stands at 85% and is projected to increase to 94% in 2010.

What are the implications of such high debt loads? First, higher taxes are almost a certainty. President Barack Obama has already indicated that former president George W. Bush’s tax cuts, which expire in 2011, will not be extended. That would result in the capital gains tax increasing to 20% (from the current 15%). Dividends will return to being taxed at ordinary tax rates. The possibility of increased taxes on capital gains and dividends in 2011 could provide a potential headwind for equity prices.

In addition to higher taxes, spending cuts are likely to occur. That might not be such a bad idea, as the U.S. government has grown under both Democratic and Republican leadership.

In 2010, additional stimulus is likely to be put to work and the U.S. Federal Reserve (the Fed) is likely to maintain its accommodative stance. Beyond 2010, higher taxes and lower spending are to be expected as the U.S. government attempts to balance its books.

Recovery in housing

Historically, real estate bubbles have taken years to unwind and it may be some time before sustained growth returns to this sector. However, real signs of improvement are beginning to appear.

In particular, existing home sales jumped 10% in October to 6.1 million sold annually – the highest level since February 2007. In addition, new housing starts appear to have troughed in early 2009, while home prices appear to have stabilized from the April lows. The housing recovery will be slow but there are early signs of stabilization, which augurs well for the U.S. economy in 2010.

S&P 500 earnings on the rise

Despite expectations for modest U.S. growth in the coming years, corporate earnings are positioned to rebound strongly in 2010, to roughly $70 to $73 from an estimated $56 in 2009, or a 25%+ increase.

Currently, the S&P 500 trailing price/earnings (P/E) ratio stands at a high 22x (forward P/E is a more reasonable 15x). With the 60%+ appreciation in the equity market from the March lows, market valuations have gotten a bit ahead of themselves near term. P/Es are likely to moderate as earnings continue to improve.

Valuations are often higher coming out of recessions but begin to compress as earnings improve. As such, gains in equity prices will be driven by earnings growth rather than further P/E expansion. Should corporate earnings improve as strongly as expected, then the U.S. stock market would be able to run further in 2010, with total returns of roughly 10% to 12%.

Where will growth come from?

Given the constraints around U.S. consumers and the fact that they account for 70% of U.S. economic activity, many question where the growth will come from over the next few years. The answer is that U.S. economic growth may be driven by corporate spending and global growth, particularly from the emerging markets.

The S&P 500 has more global exposure than ever before, with foreign sales accounting for roughly 32% of total sales, up from around 25% in the mid-1990s. This is largely the result of increased globalization and increased foreign consumption from developing nations.

TD Economics forecasts that the U.S. will grow at 2.7% on average over the next 10 years, while China and India will grow at 9.2% and 7.5% on average, respectively. While U.S. growth may be more modest in the future, emerging market growth is expected to remain strong, which bodes well for U.S. multinational companies and for S&P 500 earnings.

Midterm elections

U.S. midterm elections in November 2010 could have an impact on markets around year-end. Just a few months ago it looked like the Democrats would have a good chance of maintaining control of both the Senate and the House, given President Obama’s high initial poll ratings and a reinvigorated party base. However, that has quickly shifted as the president’s ratings have dropped significantly — to the mid-50s, according to a recent Associated Press poll.

Historically, there is a tendency for the president’s party to lose seats in Congress during midterm elections. Since WW II, the president’s party has lost House seats in 14 of the 16 midterm elections, and 12 of the 16 in the Senate. It seems highly probable that the Democrats will lose some seats in both the Senate and House, and possibly even their majority. Given the already discussed themes (that is, massive debt loads, potential tax increases and so on), these midterm elections could have a material impact on the future policies and direction of the U.S.

In this issue		February 2010
	The global economy of tomorrow: Better, stronger, faster		Save money and help the planet with eServices
	U.S. equities: Key themes for 2010