[DanRath]

The rise in US stocks since March has resulted in a boost to risk assets generally, with investors energised by the apparent ‘breakout’ in the market. Investors are taking the performance of the US stock market as an indicator of the direction of risk aversion, often on an hour-by-hour basis. This makes sense, as the US stock market is a hugely sensitive indicator both of the state of the US economy and investor sentiment. The tricky part is discerning exactly what the market is expecting, bearing in mind that it is looking forward six months or more. Has it already fully discounted the likely improvement in the US economy in coming months or will confirmation of the improvement and hopes for even better next year take the market higher?

Some analysts think the US economy could surprise on the upside over the next couple of quarters, delivering faster economic growth. This should work through the global production chain, giving a signifi cant lift to growth in Asia and other markets and boosting commodity prices. The key to the view is the turn in the US inventory cycle. Business inventories were down 9% as of May, the latest data we have. Yet final domestic demand has fallen only 3.4% from its peak, so the ratio of inventories to final sales has reached a record low. Also, the fiscal stimulus is expected to take effect during H2, while the car industry should give the economy a lift, as plants reopen after the long summer shutdown and consumers step up purchases, drawn by the new ‘cash for clunkers’ scheme.

This combination should lift the economy briskly. Some doubt if such strong growth numbers are in the stock market yet, or at the very least, some believe the market will cheer in coming months if such a strong upturn is confirmed. But beyond this temporary inventory-led bounce, the US faces major headwinds from the stress in the financial sector and the loss of wealth and borrowing power among consumers. Market forecast is that the GDP upswing will fade next year, leaving unemployment still high and policy makers floundering in the face of rising budget deficits and debt.

Concerns are mounting about the US commercial real estate sector (CRE). Prices have fallen 35%, according to the Moody’s/REAL price index, but rising vacancy rates, rising foreclosures and the difficulty of fi nding new finance point to further declines. Losses here disproportionately affect smaller and regional banks in the US, many of which are heavily exposed. As a result, they remain very cautious about any kind of new lending. Another area of concern, affecting mainly the larger banks, is credit card lending. With unemployment still rising, credit card delinquencies and losses have been surging, and issuers have responded by cutting limits. Hence, some consumers are severely constrained in their spending. Meanwhile, despite this week’s rise in the S&P Case Shiller house price index – the first monthly rise for three years – the housing sector remains very weak. Foreclosures are still on a rising trend, unemployment has not peaked yet, and obtaining a mortgage is difficult without a substantial down-payment. Market expects house prices to fall another 10-25% over the next year or so, with higher-priced houses seeing the largest declines. The fall in house prices is still the largest source of losses for banks, and has undermined consumer balance sheets.

So where does this leave the US stock market and, by extension, other risk assets? The rise in US stocks since March has been explosive, reflecting the depth of despair seen back then. Many institutions were underweight, forcing them to chase the market. But the further the market rises, the more that higher valuations need justification from good news on earnings and the economy. Second-quarter earnings have so far obliged, by generally outpacing expectations. Market expects the flow of monthly data releases to surprise on the upside over the next few months as the inventory turnaround comes through. However, the underlying problems in the US economy point to sluggish growth in 2010 and suggest US stocks may struggle to make ground beyond the next few months. It is easy to see the US locked into a Japan-style slow growth period in 2010-11. Confirmation of the economic recovery could take the market a little higher near-term, but then the underlying reality of the complex structural adjustment the US faces will weigh on it. At that point, investors in risk assets may need to look elsewhere for encouragement.