2016 and before
Outlook 2017: US equities
We are constructive on the outlook for US equities given stable economic growth, predicated on sustained strength in the consumer whose forward propensity to spend appears strong.
- We feel the consumer’s forward propensity to spend is strong given robust employment growth, a nascent uptick in wages, improved consumer balance sheets, and higher home values.
- Under our baseline scenarios, excluding Trump policy stimulus, we continue to foresee roughly 2% GDP growth.
- We continue to be constructive on those sectors that offer growth at a reasonable valuation amidst our forecast for a modest US economic growth backdrop.
We are constructive on the outlook for US equities in 2017 given stable US economic growth predicated on sustained strength in the consumer, which represents two-thirds of the overall economy. This is evidenced by robust employment growth, a nascent uptick in wages, improved consumer balance sheets, and higher home values. Based on all of these data points, we feel the consumer’s forward propensity to spend is strong.
In addition, the US industrial economy, a source of some consternation over 2016, seems to be inflecting upward. Importantly, after six consecutive quarters negatively impacted by the dual headwinds of the US dollar strength and negative drag associated with the downturn in energy, US corporate earnings inflected positively in Q3, both on a sales and earnings per share1 basis. Furthermore, US GDP inflected upward from 1.1% in Q2 to 2.9% in Q3.
Based on likely fiscal policy implementation under President-elect Trump, there could also be additional economic expansion with some estimates projecting an additional 50-60 basis points (bps) of year-over-year GDP growth. This would be a function both of tax cuts as well as increased fiscal spending.
Of course, given he doesn’t even take office until 20 January, details surrounding Trump's policy aren’t well defined, and are subject to implementation risks and policy wrangling with Congressional leadership which has historically resisted deficit spending, and potential offsetting risks to the downside given proposals on trade and tariffs.
Under our baseline scenarios, excluding Trump policy stimulus, we continue to foresee roughly 2% GDP growth. Using this as a proxy for corporate top-line growth (assuming a 1.5x multiplier), our confidence in 1-2% improvement in corporate margins, and 1-2% additional upside associated with stock repurchases, we are confident in a 6-8% earnings growth outlook.
Compelling sector valuation stories
On valuation, while we appreciate that the S&P 500’s forward price-to-earnings (P/E)2 ratio is trading at the higher end of its five- to 10-year historical range, we feel that on an earnings yield basis, 5.8%, today’s market represents a very compelling valuation. It is compelling relative to today’s yield on 10-year Treasuries of 2.55% and other fixed income alternatives.
Further, despite “headline” S&P valuations, we believe there are very compelling sector valuation stories, such as technology and healthcare, where growth is under-appreciated relative to P/E ratios below 15.0x.
It’s important to note that much of the expansion in valuations over the last few years has been in bond proxies3 that have benefited from money inflow associated with quantitative easing. Accordingly, any lift in areas where valuations have stagnated, like technology, healthcare and consumer, could add to our projected earnings growth outlook and result in increased annualised US large cap returns.
There are a few risks to our outlook. The first is why amidst a backdrop of decent jobs growth, the US isn’t seeing greater wage growth and GDP expansion. Given that wages and CPI are now inflecting, it seems clear that the economy has worked through excess slack in terms of unemployment as reflected by a U6 unemployment number4 that is now below 10%.
As for GDP, Q3’s recent inflection to 2.9% validates our contention that GDP figures over the last three to four quarters had been depressed by the ephemeral impact of a stronger dollar. This negatively impacted the 34% of S&P sales that are international and those earnings impacted by the collapse in oil price. These factors are estimated to have negatively impacted GDP by 50 and 70 bps respectively.
Fed policy change not definitively negative
The second risk to our growth outlook relates to risk of inflation and the prospect of Federal Reserve (Fed) policy change. It is important to note that, just recently, investor anxiety centered on the fact that there wasn’t enough inflation. We think that today’s uptick in inflation is only modest – a CPI rate of only 2.2%, versus historic levels of nearly 3-4% during similar periods of 5% unemployment.
In addition, as history bears out in policy moves in 1994, 1999, and 2004, market performance subsequent to Fed policy change is not definitively negative. In fact, in those three cases, although of course past performance is not a reliable indicator of future results, 12 months after initial Fed moves the markets were on average 6% higher. Ultimately, we feel any Fed action is emblematic of better growth in the US economy. We feel concerns that inflation will drive higher expenses (labour costs, etc... ) are balanced with increased topline prospects associated with improved consumer wage profile.
The third risk relates to uncertainty associated with President-elect Trump. Given his lack of governmental experience, he represents uncertainty that the market traditionally fears. Additionally, given the fact that the US House of Representatives and Senate surprisingly maintained Republican leadership, there are greater odds of more transformative change.
It is important to note, however, many of Trump’s highest priorities are bi-partisan issues like fiscal stimulus: tax cuts and infrastructure spending. Moreover in areas where he might challenge the status quo, it is important to recognise he faces a Republican House that is fiercely independent, has historically defied leadership, and doesn’t like deficits. And while he may look to dismantle the Affordable Care Act and challenge trade agreements and enforce tariffs, his campaign issues were less defined. These need to be prioritised and it will take time to find passage through the House and Senate and then implement.
Growth at a reasonable valuation
As always, we continue to be constructive on those sectors that offer growth at a reasonable valuations given the premium earnings growth should warrant amidst our forecast for a modest US economic growth backdrop. Those would include technology and consumer where we find strong potential for earnings upside relative to Wall Street consensus.
We are also more favourably disposed to cyclicals5 like financials and industrials given the turn we were seeing in US inflation prospects even before a Trump fiscal impulse, as well as increased global GDP and commodity prospects after solid doses of global QE programmes.
1. This is the profits of a company attributed to each share, calculated by dividing profits after tax by the number of shares.↩
2. This is a ratio used to value a company’s shares. It is calculated by dividing the current market price by the earnings per share, or forecast earnings per share for the “forward” P/E.↩
3. Equities that exhibit the same defensive, yield-generating characteristics as bonds↩
4. This is a broader measure of unemployment which also captures underemployment, it includes the total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons↩
5. Stocks whose share prices are directly related to the economic or business cycle↩