Markets & Economy

2017 Outlook: U.S. Equities

January 19, 2017
The fundamental backdrop for the U.S. stock market could remain favorable in 2017 but with more uncertainty than usual as we enter the New Year.

Key Points

  • President-elect Donald Trump’s plan to cut taxes, moderate regulation in some sectors, and promote infrastructure investment could boost the economy and corporate earnings.
  • The fundamental backdrop for equity investing should remain favorable.
  • Corporate earnings are poised to show continued recovery in 2017.
  • Stocks performed well in some rising rate environments historically.
  • Protectionist trade policies and possibly higher deficits along with tensions pose key risks.

FUNDAMENTALS FAVORABLE

U.S. equity investors entered 2017 facing even more uncertainty than usual. But as indicated by the postelection market rally, the fundamental environment for equity investing could remain favorable.

President-elect Donald J. Trump’s plans to reduce taxes, moderate regulations, and increase infrastructure investment are all potentially supportive of stronger economic growth and better corporate earnings, particularly for such sectors as industrials, financials, and health care.

However, it’s uncertain how successful the Republican leadership will be in enacting and implementing these policies. How long it would take for these steps to have a potentially positive impact, also is not clear.

Key risks include possible renegotiation of key trade agreements, resulting in higher tariffs or other trade frictions. Also, if federal spending increases and tax cuts are not offset by spending cuts or a revitalized economy, concerns about inflation, rising deficits, and ballooning national debt will move to the forefront.

A bearish scenario ultimately could come about if, after several years, the government has not stimulated much growth in the economy—at the costs of growing trade tensions, more federal borrowing, higher deficits, and sharply rising interest rates. However, I don’t expect that outcome, and overall there are reasons for an optimistic market outlook. If the Republican-led government can execute its initiatives skillfully, there is a reasonable chance for acceptable and perhaps even above-average U.S. equity returns over the next 18 to 36 months.

As 2017 begins, U.S. stock valuations on average are reasonable by almost any measure. Growth stocks are selling at a lower-than-average premium to cyclical, value-oriented stocks, particularly among the larger companies.

The interest rate environment, while not ideal for growth investors, is also generally benign. Interest rates should continue to move higher over the next couple of years, with short-term rates perhaps reaching 2% and longer-term rates around 5%. History shows that rising rates did not derail the case for equities if accompanied by an improving economy. History has shown that stocks performed well in some rising rate environments. (See Figure 1.)

Figure 1: Stocks Usually Have Gained With Rising Rates

10-Year Treasury Yields and S&P 500 Performance

file

Past performance cannot guarantee future results.
*A basis point (bps) is 1/100th of 1%.
Source: Strategas Reseach Partners.
The periods in the chart reflect all periods of rising rates since the early 1990s.

Meanwhile, the S&P 500 Index’s dividend yield remains attractive relative to current interest rate levels, even with the sharp rise in rates following the election.

Corporate earnings, which had contracted for five consecutive quarters through June 2016, should continue a recovery that started in the third quarter of 2016—particularly if there is corporate tax reform and infrastructure investment expands.

Wall Street estimates call for a 11.9% gain in S&P 500 earnings in 2017 and 5.6% growth in revenue as the energy sector becomes less of a drag. Energy companies are slowly recovering and are likely to improve their margins and profitability.

Nevertheless, investors should keep in mind that, even with tax cuts, less regulation, and more infrastructure spending, expectations for cyclical improvement in the economy could be too optimistic.

SECTOR OPPORTUNITIES

We believe the best opportunities for earnings growth are in the large-cap growth area, particularly in these sectors:

  • Within health care, certain biotechnology companies are innovating and have had rapid revenue growth. There also are attractive opportunities among medical device companies and managed care companies.

  • In the technology sector, we remain optimistic about the dominant firms in the segment. Select companies generating sustainable or recurring service revenue are attractively valued, while those participating in the growth of cloud computing and social networking should achieve strong secular growth. Companies manufacturing semiconductors used in autonomous driving and touchless payments could also see brisk growth.

    Several technology companies had setbacks after the election given the view that the Trump administration could hurt the sector with trade and immigration policies, supply chain disruptions, and possibly antitrust actions. However, I don’t consider this the most likely outcome.

  • The financials sector has improved on expectations for less regulation and a steepening yield curve (longer-term rates increasing more relative to short-term rates, which boosts bank profits). Those factors could drive earnings improvements.
  • Strong consumer discretionary firms should continue compounding good earnings and would likely benefit if tax cuts put more money in people’s pockets.
Figure 2: The Current U.S. Bull Market Versus History

The U.S. bull market—as measured by the S&P 500 Index of large-cap stocks from March 9, 2009, through the end of 2016—has persisted longer than the average U.S. bull market going back to the 1930s and delivered better-than-average returns. Excluding the current bull market, U.S. bull markets since the 1930s averaged a duration of 57 months and returns of 164.5%.

As of October 31, 2016

file

Past performance cannot guarantee future results.
Source: Strategas Research Partners.

Given U.S. political uncertainties, investors should focus on the time-tested process of investing in companies with durable earnings and free cash flow growth—and not be too swayed by postelection expectations.

Many of these high-quality companies have low levels of debt and tend to pay high tax rates, so they would benefit from corporate tax reform.

Of course, investors also should be mindful of the risks. In addition to those from possible unfavorable policy outcomes, concerns also exist over lackluster global growth and possible economic dislocation from Brexit, as well as myriad geopolitical tensions. If the surge in the dollar persists, it could have a negative effect on U.S. competitiveness and growth and undermine profits for multinational companies, which would see a decline in the value of their significant foreign earnings.

Importantly, this bull market, which began March 2009, has surpassed the average bull market in return and duration. Market strength over the past few years tempers the amount of potential appreciation. (See Figure 2.)

In general, investors should maintain a healthy dose of skepticism and have modest expectations. At the same time, an improving earnings trend, pockets of strong growth opportunities, and possibly better economic performance could produce another good year for U.S. equity investors.

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The views contained herein are as of January 2017 and may have changed since that time.

Past performance cannot guarantee future results.

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