US recovery worries make investors wary

Despite gloomy headlines, corporate profits have begun to improve, butdoubts remain about durability of US revivalOne area that could create problems for the US is the recent resumptionin the growth of the trade deficit with the rest of the world

Investors who are fully exposed to equity markets could be forgiven for feeling a little queasy as they digest the recent spate of profit warnings from companies such as IBM, Nokia and Ericsson, among others.

Outside of the UK and Ireland, most companies report earnings on a quarterly basis.

If one were to cast judgment on the basis of the headlines in the financial press, the conclusion would be that corporate profits have not yet begun to benefit from better economic conditions.

The reality in fact is quite the contrary, when a comprehensive review of reported results is considered. For example, in the US market 219 companies within the S&P 500 index have already reported their first-quarter earnings.

Of these companies only 29 have failed to meet analysts' expectations, whilst 132 companies have managed to do better than broker profit forecasts. The balance of companies produced financial results more or less in line with expectations.

The discrepancy between these figures and the more negative slant being highlighted in the financial press would seem to be due to two factors.

Firstly, the technology and telecommunications sectors continue to suffer from weak demand and bloated cost bases, and there now seems little likelihood of any meaningful recovery in these sectors until late this year or early next year. The high-profile nature of these companies means that they continue to generate a proportionately greater level of public interest than many longer established companies.

A second factor relates to the extent to which many companies that did report good Q1 earnings were somewhat downbeat regarding profits for the remainder of the year. This is a somewhat worrying feature of company statements as it suggests that corporate profit growth may well be very subdued for the remainder of this year.

Therefore, it is probably the continued high degree of uncertainty concerning corporate profitability for the remainder of this year and beyond that has created a negative tone to the reporting of Q1 financial reports. In current stock market jargon, the visibility of earnings going forward remains poor for many companies.

The root cause of this lack of visibility regarding corporate earnings resides in the uncertain prospects for the US economy. Recent statements from Federal Reserve chairman, Mr Alan Greenspan, have served to reinforce the view that there are still question-marks regarding the durability of the US economic recovery.

One area that could create problems for the US is the recent resumption in the growth of the trade deficit with the rest of the world. Throughout the long economic expansion of the 1990s the US trade deficit grew relentlessly.

This did not create any problems for the economy, since the flow of private sector investment funds from abroad into the US was enormous over this period and comfortably exceeded the trade deficit. The net result was that the dollar appreciated throughout this period.

Over the 12 months to February 2002, the US trade balance amounted to a deficit of $423 billion (€476 billion). The shallow US recession of 2001 temporarily interrupted the inexorable rise in the size of this deficit. However, in recent months the deficit has begun to widen again, from $25 billion in December to $28 billion in January, followed by a further deterioration to $31.5 billion in February.

If the US economy continues to lead the world out of recession, then the US trade deficit is almost certain to widen further.

A poll by the Economist magazine of economic forecasts shows that forecasters are now expecting the US current account deficit to grow from -4.2 per cent of GDP in 2002 to -4.5 per cent of GDP in 2003. If the European economic recovery is below par, and if Asian economies fail to resume growth, then the US trade imbalance could well deteriorate at an even faster rate than currently forecast.

Of course as long as European and Japanese investors are prepared to continue to invest in the US this need not be a problem. One warning sign that the US trade deficit was going to become problematic would be if the dollar began to decline against the euro and the yen.

So far there is very little sign of this occurring and if anything the dollar has strengthened further over the past three to six months.

One symptom of this growing trade deficit is the growing political pressure within the US towards protectionism. This manifested itself recently in the imposition of tariffs on steel imports by the US administration to protect employment in the US steel industry.

The EU has threatened retaliation across a range of products in order to pressure America to reverse its decision. It is unlikely that this spat will develop into a serious trade war.

Nevertheless, it does highlight the fact that at some point the US trade deficit will have to reverse trend and that this point may come sooner rather than later.