Bull Set to Charge Ahead?
Maybe it’s an early dose of Christmas cheer, but as December moves ahead, we can’t help but be optimistic on global equity markets for the remainder of 2017 and into 2018. Many of our mid-November concerns have been alleviated as small-cap domestic equities (Russell 2000) and the Dow Jones Transportation Average have rebounded, outperforming the S&P 500 from November 17 through month-end. The high-yield index, after a nasty little sell-off in late October/early November, has rallied back and again carries a yield around levels seen in late August. Both the relative outperformance of small-caps/transports and the rebound in high-yield bond indices are positive indicators of healthy investor risk appetite, as “buy any dip” seems to rule the day.
Domestic equities continue to have a strong fundamental tailwind as earnings and revenue growth have been impressive. Current projections have 2017 S&P 500 EPS growing 10.1% above 2016 and 2018 EPS growing 10.8% over the current 2017 estimate – without considering the potential earnings boost from tax reform. The U.S. dollar index (DXY) has weakened substantially this year, dropping 9% through November, boosting earnings expectations for U.S.-based corporations exporting into improving international economies. The S&P 500 garnered 30% of its last twelve months of revenue from outside the U.S., and a weak/weakening U.S. dollar appears poised to boost that number higher still.
Wage growth and commodity price inflation are well worth monitoring. Companies being forced to pay higher wages to attract and keep qualified employees in a tightening labor market could ultimately see their margins crimped, although this doesn’t appear to be of immediate concern as average hourly earnings were up 2.6% year-to-date through November, short of 3.0%-3.5% growth that would normally be associated with full employment. Commodity price inflation has picked up due to an uptick in energy prices - the price of a barrel of West Texas Intermediate (WTI) crude oil has gone from $46 at the end of August to $57.40 at the end of November – as well as prices of industrial metals such as copper. Pricing power will be of immense importance for manufacturers as an inability to pass along price increases on throughputs to end consumers could be a canary in the coal mine for forward earnings expectations.
The S&P 500 appears stretched relative to historical norms trading at 19.7 times projected full-year 2017 EPS of $131.69, versus a 10-year average trailing 12-months P/E of 17.3. That said, earnings have surprised to the upside over the past couple of quarters, and forward earnings expectations for 2018 have been ratcheted higher for two consecutive months. Potential positive catalysts remain for global equities and the fundamental underpinnings of the rally remain solid. Valuation has been the primary source of anxiety for domestic equity investors, but valuations can stay elevated for protracted periods of time, leading investors to miss out on returns while waiting for shallow pullbacks to get more invested. The strong upward trend for domestic equities remains, and we have no desire to fight it.
While we remain positive on domestic equities, we are increasing allocations to both international-developed and emerging markets. Valuations internationally are attractive relative to those of domestic equities, and, broadly speaking, international economies are roughly where the U.S. was 3-4 years ago from both a monetary policy and fundamental backdrop perspective. This situation should leave ample economic runway before inflation potentially forces central bankers to aggressively raise interest rates to combat it. We are cognizant of the performance of both the MSCI EAFE (international-developed markets) and MSCI EM (emerging market) indices, up 23.7% and 32.9% on a total return basis year-to-date, respectively; however, since November 30, 2007, both indices have actually posted a negative price return. It has truly been a lost decade for international stocks, broadly speaking. The S&P 500 and Russell 2000 are up 78% and 101% in price, respectively, over the same time frame. We believe international equity markets are “due” for some catch-up relative to domestic equities and are positioning accordingly.
Source: Bloomberg, FactSet
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