Wall Street's set fair, but will the dollar spoil the party?

President Bush's inauguration has passed. His position is strong, the country still flush with cheap money and corporate America has plenty of profits with which to reward investors. Never mind that the US has a trade deficit of $60.3bn, equal to 6 per cent of its gross domestic product (GDP) - or that the people of Iraq might not quite be on message. Just to reassure doubters, Abby Joseph Cohen, Goldman Sachs's esteemed Wall Street analyst, has predicted a broad 10 per cent advance in US share prices.

President Bush's inauguration has passed. His position is strong, the country still flush with cheap money and corporate America has plenty of profits with which to reward investors. Never mind that the US has a trade deficit of $60.3bn, equal to 6 per cent of its gross domestic product (GDP) - or that the people of Iraq might not quite be on message. Just to reassure doubters, Abby Joseph Cohen, Goldman Sachs's esteemed Wall Street analyst, has predicted a broad 10 per cent advance in US share prices.

But if that happens, it will be in dollar terms. And for UK investors in the US, currency is the catch. Over 10 years to the end of 2004, for example, dollar returns on the broad MSCI US index were 212.6 per cent. But converted into sterling, the same index returned just 154.7 per cent. "The dollar declined by 42 per cent from June 2001 to December 2004," says Frederick de Merode, strategist at Fidelity Investments. "It punished UK investors."

Currency movements are notoriously hard to predict, but since December the dollar has recovered by 5 per cent against the pound. Why? "Partly because markets believe that US interest rates are set to increase over 2005," says Steve Andrews, economist at F&C Investment Management, "and partly because there is still healthy demand for US financial assets by foreigners."

Still, foreign investors are taking advantage of the weak dollar to buy cheap assets in the US. In November 2004, the latest data available, foreigners bought a hefty $14.5bn of US equities, and the People's Bank of China purchased no less than $7.95bn of US Treasuries. "All good for the dollar," says Mr Andrews, "but it is still weak on fundamentals, and could fall and rise and fall again."

This matters to investors. "The US trade deficit and the value of the dollar are symptomatic of much that is wrong in the US economy," says Patricia Wilson, an analyst at Scottish Widows Investment Partnership. What's wrong has been a consumer-led boom fuelled by cheap borrowing. About 70 per cent of the US's GDP is made up of consumer spending, and US consumer spending has been growing at twice the rate of growth in earnings.

What does this say about investing in the US? "We are broadly positive," says Ms Wilson, "but it is too early to say whether and exactly how an economic slowdown will effect the markets. There is still room for things to go wrong." In other words, if consumer demand slows too fast and the dollar strengthens, the economy might go into recession.

So much for the economists. Managers of US funds are a lot more positive. "Over the last two years, we have seen a big recovery in company profits and above all in their free cash-flow," says Rupert Della-Porta, who manages US funds for F&C Investment Management. This means that companies can reward their investors by increasing dividends, by buying back stock, and by strengthening balance sheets and creditworthiness. Of the 10 per cent total return predicted this year from US equities, 2 per cent is expected from dividends, with the balance from capital growth. This is the highest dividend level for many years.

Indeed, profit growth may slow in some sectors, but a weak dollar will have a positive impact for many large US companies who export. "Consider how many of us are flying to New York for a spot of tourism and shopping," says Mr de Merode.

Elsewhere, the impact will be more subtle. The balance sheets of some US multi- nationals will be strengthened by the weak dollar. "This is good for any company that exports," says Mr Della-Porta, "particularly for big industrials, pharmaceuticals and some of the tech companies."

Foreign earnings also gain, and look set to be a market theme in 2005, but the same story has a negative side. This week Alcan, the world's largest aluminium producer, issued a profits warning and blamed the weak dollar. Other, less visible, changes have been big efficiency gains by US companies, and the increasingly more efficient labour market.

All these strands are being pulled into an emerging consensus on US markets. During 2004, the S&P MidCap 400 grew by 16.5 per cent, and the S&P SmallCap 600 by no less than 22.65 per cent in dollar terms. But the large-cap S&P 500, roughly equivalent to the FTSE 100, grew by only 10.9 per cent.

"This says that small and mid-cap shares may be losing steam," says de Merode, "and could start to look pricey in relative terms." Mr Della-Porta judges: "Large caps are due for a comeback, but stock picking - looking at each company on an individual basis - is the only way to avoid bad investment choices."

There is also the option of investing in the US via collective funds, to diversify risk. A good place to start is with the 95 funds that comprise the Investment Managers Association (IMA) "North America" fund sector. For the 12 months to 31 December 2004, the average return for this sector was a disappointing minus 2.87 per cent. Worse still, the top-performing fund, Fleming Family & Partner's US Mid Cap Value, rose by 10.4 per cent, but that is only available to the firm's private clients.

The rest of us will have to take second best, in this case Inscape's US Equities fund, which grew only 2.8 per cent. All but the 13 top-performing funds in this sector lost money for the year, because of that weak dollar.

But, looked at over 10 years, sector returns look more rewarding. Over this period, Fidelity's American fund was top performer, returning 413.8 per cent. In the area of smaller companies, Schroder's US Smaller Companies and Scottish Widows' American Smaller Companies returned 7 to 8 per cent.

There is also a small number of investment trusts. The performance of these has been stronger than unit trusts. Take the American Opportunity trust, which invests in US large-cap shares, and which grew 11.1 per cent last year. And four trusts investing in US smaller companies achieved an average return of 14 per cent. Of these, the F&S US Smaller Companies trust returned just 2.5 per cent, the JP Morgan Fleming US Discovery trusts 8 per cent, the Renaissance US Growth trust an impressive 17 per cent and the North Atlantic Smaller Companies trust a whopping 26.4 per cent. American funds, much like the great nation itself, offer a wealth of opportunities.

AMERICAN SHARES FOR YOUR BUY LIST

"We have always had a small number of clients who want to buy US shares," says Hilary Cook, a private-client stockbroker at Barclays Stockbroker, "but this appetite is growing."

Some UK investors buy direct to diversify their portfolios, and others just want to hold favourite stocks. Dealing costs for US shares are high relative to those for UK or European equities, and only the larger firms of UK stockbrokers offer clients the facility to trade. Barclays charges a competitive minimum of £45 a deal.

Its recommendations include the "old industry" car-maker General Motors. Why? "The company faces headwinds, but look at its current price-to-earnings ratio of just 8.4 times the consensus estimated earnings for 2005," says Cook. "High risk in a risky sector, but cash generative." Microsoft Corporation also gets a "buy" recommendation. Judged on absolute terms, the share is not cheap, trading on a price-to-earnings ratio of 24 times 2005 estimated earnings, but its "franchise strength" is immense. "Despite all the criticisms, and despite things such as antitrust cases in the US, Microsoft still provides most of the software we use on our personal computers," says Cook, "and you have to wonder if this is not a natural monopoly."

Meanwhile, firms such as Toll Brothers, luxury home builders, American Eagle Outfitters, which makes casual clothes and Landstorm Systems, a trucking cfirm, have all found favour with with US smaller company trusts, but brokers advise caution, because of their volatilty.

"The US market is huge," says Cook. "It's an ideal hunting-ground for keen private investors who want to do their own research."