Looking ahead in 2017, we have a positive outlook for equities but with a few caveats. Our positive outlook is based on the following main areas:
- Trump pro-growth agenda: Trump pro-growth policies will likely benefit company earnings here in the United States, however, these benefits won’t be fully recognized until 2018. Although equities should enjoy a tail wind, the ride will be volatile. That said, investors should be aware of the upcoming short-term risks to corporate earnings (more details under caveat #1).
- Earnings growth: In terms of earnings potential, we prefer U.S. equities over international equities, small caps over large caps, and developed markets over emerging markets. We are aligning with earnings growth prospects, which our research shows that stock prices follow earnings over the long-term and valuations matter when earnings growth stops.
- Growth at a reasonable price (GARP): In terms of style, GARP should outperform after the worst performance year in history in 2016. Moreover, we believe cyclical value stocks will be the main beneficiaries of broadening growth prospects in the United States and globally. Expensive defensives and bond proxies (dividend yield plays with low growth such as utilities and telecoms) will be more likely to underperform with increasing interest rates and the availability of more earnings growth opportunities in equity markets.
Our positive stance is aligned with earnings growth prospects in equities. For example, 10% expected growth in U.S. earnings should bring 10% returns to U.S. equities (see the chart below).
As investors look ahead to 2017 they should also consider the following caveats when investing in equities:
- Don’t expect much for rerating U.S. valuations are high since price-to-earnings (P/E) rerating has already happened, so we don’t expect to see much rerating throughout the year. Accelerated earnings growth would be the only catalyst for further rerating.
- U.S. small caps have the highest earnings growth prospects, but also the highest valuations. Delivery of the earnings growth will be the key. U.S. small caps will be the main beneficiaries of Trump’s pro-growth policies such as tax-cuts and infrastructure investments, but the full earnings benefit will not be seen until 2018. As a result, some disappointments may be under way in 2017 before we have visibility on further earnings surprises.
- Emerging markets also have high earnings growth prospects and the cheapest valuations. Let’s face it, it’s hard to generalize emerging markets due to the very different countries and companies. However, our cautious outlook resides on potential further currency weakness and country risks, especially with the current account deficit countries: Turkey, South Africa, Mexico, and Malaysia. Further capital outflows and currency depreciation will likely create balance of payment issues for these countries.
- Further Chinese currency depreciation will present risks to other Asian emerging market countries that compete for similar exports. In addition, border tax adjustment will be a big deal for emerging markets. In fact, most foreign investors and companies aren’t even aware of it so its potential of making U.S. imports more expensive isn’t fully priced into emerging market earnings growth expectations.
- As a result, Trump’s pro-growth policies are positive to earnings for U.S. companies, but it may be a headwind for international counterparts. However, a barbell with the United States on one end and emerging markets on the other may work well to balance increasing growth and cheaper valuations at the same time
- Expect heavy penalties for short-term disappointments. There will be some short-term disappointment to earnings so the market will likely penalize those disappointments. Where do we see the disappointment coming from? Export-oriented large U.S. companies within the industrials and technology sectors where stocks rallied; the strong U.S. dollar will be a headwind in the short-term. We believe infrastructure spending will have more time to play out so there will be little earnings benefits to these companies in 2017. However, these stocks have already rallied, so a short-term pull back and disappointment are likely.
- Expect volatility. Expectations are high for Trump’s policies to generate growth. However, we’re already hearing rumors around China getting ready to counter act Trump’s policies even though these policies are still unknown! Potential trade wars will likely create volatility in the short-term, so be prepared for increased market volatility in 2017 due to the possible retaliatory policies from China and others.
Positive earnings surprise potential
Leading indicators of macroeconomic activity has been improving, supporting the stock market rally and potential acceleration of earnings growth. Specifically, over the last 30 years, the National Federation of Independent Businesses (NFIB) survey has been a leading indicator of real gross domestic product (GDP) growth. In turn, we believe there may be meaningful upside risks to output growth over the next several quarters (see chart below).
Looking beyond the caveats, where will the positive surprise be? We see this happening within the healthcare, financials, and energy sectors.
- Healthcare: Healthcare was the worst performing sector in the United States last year due to drug pricing uncertainties caused by both U.S. Presidential candidates focusing on healthcare as a way to lower rising costs. This created uncertainty and despite strong earnings growth, these stocks de-rated. In January, we have already seen branded drug prices go up by 7.8%, consistent with their 10-year average of 8%. It is business as usual for these companies. In addition, Trump’s priority has been to repeal and replace the Affordable Care Act, which also serves to lower the cost within the healthcare system. With further earnings support and much cheaper valuation relative to the market, healthcare stocks are likely to outperform in 2017.
- Financials: Rising interest rates have already been positive for financial company earnings. Although the increasing rate has already been reflected in current earnings estimates, other potential positives such as improving credit profiles, consolidation opportunities, and cost-savings from potential deregulation with business-friendly administration have not. We expect continued outperformance of financial companies with the short-term caveats as discussed above.
- Energy: Finally, the new U.S. government’s more aggressive energy policy will likely “jump start” energy investment and production even though we believe the upside in oil prices is limited at around $60 per barrel. However, this is positive for U.S. land drillers and low-cost producers of shale oil. Consolidation opportunities with M&A activity would also create earnings leverage and accretion to companies with strong cash flow generation and strong balance sheets.
In summary, we’re positive on equities, albeit with a few noted caveats around what to expect. Even though more volatility is likely on the horizon in 2017, we believe earnings surprise potential could drive equity markets upward.
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