Both domestically and throughout the globe, most equity markets generated 20%+ returns in 2017. Last year was a record for equities in many ways. Domestically, U.S. markets saw record low volatility. Additionally, it was the first year equities rose in every single month. Finally, U.S. equities ended 2017 with a record streak of 681 days since the last correction of over 5%. Considering equities typically experience at least one 10% correction per year, 2017 was a unique year. Outside the U.S., most equity markets actually performed better than the U.S. as earnings rebounded and P/E’s expanded. With this backdrop, what are our views entering 2018?
In the U.S., after growing 1.5% in 2016, gross domestic product (GDP) rose probably 2.3% in 2017. Due to the recently signed corporate tax reform, 2018 will see growth tick up to 2.5%-3.0%. After pushing back overall spending in advance of tax reform, business spending will likely rise. There are also twin tailwinds from the rebuild after two massive hurricanes and a reverse of the spending collapse during the bear market in the oil sector. Government spending on healthcare and infrastructure will rise, and the U.S. should be a net exporter, which aids growth.
Regarding corporate earnings, 2017’s 11% growth was a welcome sign after earnings grew 0% in 2015 and 2016. Earnings were expected to grow about 6-7% in 2018 prior to tax reform, but now with a lower tax rate, S&P 500 earnings could grow 10-14% to as high as $150 per share. A major question is how much wage increases will offset the lower corporate tax rate. A more conservative assumption pegs 2018 earnings per share at about $145.
Valuation is an ever present debate in the U.S. equities markets. Using previously mentioned earnings of $145, the S&P 500 starts the year at a P/E of 18.5x 2018’s earnings. The debate is simple: Bears say markets trade at a long-term average P/E of about 15x next year’s earnings, meaning the S&P 500 is 25% above the average valuation. They would add the Fed is now raising interest rates, inflation has bottomed, and wage growth will cause margins to peak. Meanwhile, Bulls say with 10-year Treasury interest rates at 2.40%, and inflation tame, there is no reason why the P/E cannot rise to 20. Our valuation view today is similar to early 2016:
January 1, 2016: S&P 500 price 2239, Earnings for the year = 132, P/E 17.0x, 10-Yr U.S. Treasury 2.44%.
2017 Outlook: “Equities rise as long as interest rates and inflation are tame. Interest rates below 3% (10-yr UST) and inflation (core CPI) under 2.3% are keys”.
January 1, 2017: S&P 500 price 2674, Earnings for the year = 145, P/E 18.5x, 10-Yr U.S. Treasury 2.41%.
2018 Outlook: “Equities rise as long as interest rates and inflation are tame. Interest rates below 3% (10-yr UST) and inflation (core CPI) under 2.3% are keys. Additionally, we believe the fourth quarter of 2017 marked a very important shift in U.S. equities toward value stocks and away from some growth sectors. Our valuation stoplight is flashing a warning signal, especially if interest rates and inflation rise in 2018.”
Five out of eight metrics are overvalued. The combination of 10-Year U.S. Treasury interest rates rising above 2.75%, the P/E rising by 5%, and CPI rising well above 2% would turn the remaining metrics red.
Our recent U.S. equities bias toward value versus growth: During the summer of 2017, the investment team added a number of inexpensive, cyclical, “value” oriented positions to the portfolio, while trimming growth oriented top performing positions. We believed then, and continue to believe today, that many value oriented companies are experiencing a positive earnings inflection, while trading at an extreme discount to growth companies. In addition, the positive earnings inflection will enable their earnings growth to outpace most growth companies. At the same time, value companies on average have a higher percentage of their revenue derived from the U.S., and they should benefit more from lower tax rates, as the average value company sports a 30% tax rate. The following chart shows the extreme return differential over the last ten-years, which we believe has peaked.
Largest Russell 1000G holdings: AAPL, MSFT, FB, AMZN, GOOG, V. P/E 26x forward earnings.
Largest Russell 1000V holdings: XOM, BRKB, JPM, JNJ, BAC, PG. P/E 18x forward earnings.
Finally a word on sentiment. Most market strategists talk about earnings peaking or geopolitical events being the main risks to U.S. equities. Besides interest rates and inflation, we believe U.S. equity markets are presently as bullish and complacent from a sentiment standpoint as any period in history. Sentiment is overly bullish, cash levels are low, volatility is at a record low, small bubbles like cryptoassets are evident, along with the universal belief that present conditions will continue into the future. Record high levels of bullishness, consumer confidence, and certain cyclical economic indicators like ISM (Institute for Supply Management), are typical indicators of market pauses or tops versus bottoms. Luckily, as proven in late-2015 through early-2016, a swift 10-15% correction can quickly reverse sentiment froth.
OPCM increased our allocation to foreign equities toward the end of 2015. The summary of our view was that earnings were close to bottoming, while interest rates were extremely accommodative at 0%, and the valuation differential with the U.S. was high. The variables were evident as the U.S. Fed was shifting interest rate policy to rate hikes versus cuts. After two years of outperformance for foreign equities, our general thesis has not changed.
In Europe, GDP should surpass 2% with countries like Germany outpacing the EU as a whole. Inflation should creep higher, but remain below average. Finally, earnings should grow at a similar pace to the U.S., with a lower P/E. Additionally, monetary policy should be neutral versus the U.S. tightening bias. We continue to allocate to Europe and Germany in particular. The European Central Bank (ECB) should keep a relatively loose monetary policy, and will likely buy back bonds through the first half of 2018. The key to Europe in 2018 may not be the standard worries over earnings or valuation. The key metric that could alter the stock market trajectory could be inflation, if it rises at a faster pace than the ECB expects.
Shifting to Asia, China GDP should grow well over 6%, which will actually be beaten by India, where our bias is toward the Indian consumer sectors. Finally Japan, our worst performing foreign equities holding, up 25% in 2017, should see steady growth, low inflation, and an expanding P/E.
Our exposure to Latin America is low, however a few countries such as Brazil are in the early stages of a potentially real recovery spurred by interest rate cuts and actual business and government investment as opposed to simple consumer consumption.
Finally, in emerging markets, our overweight is unchanged as higher earnings growth is teamed with a 30% discount valuation to developed markets. Additionally, commodities bottomed in 2017, which along with a flat U.S. dollar would be an additional positive.
Although most of the chatter regarding equities is about tax rates and earnings, 2018 may be the first year in decades when interest rates, inflation, and sentiment are as important as earnings growth and valuation.