United States: Life after liftoff
The Fed has consistently communicated an intention to hike rates gradually. But the exact meaning of “gradualism” is open to interpretation. Our favoured scenario predicts continued moderate 2.0-2.5% real GDP growth and a tighter labour market that helps drive inflation higher. In such an environment, we think the Fed would feel comfortable hiking four times in 2016 (i.e. at every other meeting). Indeed, that would be the most gradual hiking cycle in the modern era of U.S. monetary policy. However, it could be perceived as aggressive relative to current market valuation, which appears to be pricing in only two hikes in 2016.
On a standalone basis, the U.S. appears resilient enough to weather higher interest rates. But the impact of further dollar strength – on both the U.S. and other global markets – could stay the Fed’s hand. Fed liftoff is a signal of a more robust expansion, but that isn’t to say that U.S. financial markets are without risk.
Years of asset purchases and ultra-accommodative monetary policy have pulled market returns forward. As a result the U.S. equity market is now fully priced at 17 times forward earnings, based on the S&P 500® as of Dec. 11, 2015. Expensive valuations act as a headwind to the market, and further upside in 2016 will hinge increasingly on corporate earnings power. Our baseline forecast calls for low to mid-single-digit U.S. earnings growth in 2016 as the large drags from the energy and materials sectors fade. But, in our view, the risks to earnings are still skewed modestly to the downside. In particular, we anticipate the unemployment rate will fall to 4.5% (or lower) by the end of 2016, and that could trigger upward pressure on wages, which would eat into profit margins.
The good news is that we do not see a recession on the horizon for 2016. The U.S. Business Cycle Index supports that view. And more fundamentally, we do not observe the types of economic imbalances today that would typically drive a recession. The labour market is nearly back to normal, but it isn’t overheating; business investment remains below trend (and well below the worrying levels of the late 1990s); and household balance sheets are much healthier than they were in the run-up to the financial crisis. The corporate credit cycle, however, is moving into the later innings. For the time being this does not appear to be a systemic risk, as low interest rates make it easy for businesses to service their debt. But corporate credit will be a watch point for investors in the years to come.
A tightening labour market poses upside to wages and downside to earnings
Percentage-point deviation of unemployment from its normal level
*labour market slack is when there are more workers than jobs
Sources: Bureau of labour Statistics, Russell Investments as of Nov. 30, 2015
We maintain our underweight to the United States equity market in global portfolios as expensive valuations offset a modestly favourable macro backdrop.
- Monetary policy: We expect the Fed to hike interest rates four times in 2016 and for that to drive further upside in the U.S. dollar and push the 10-year U.S. Treasury yield towards 2.8% by the end of 2016.
- Stronger dollar: We expect the dollar to appreciate by another 5% to 10% in 2016 on a trade-weighted basis, driven by policy divergence between the U.S. and other major central banks. A stronger dollar is a drag on multinationals’ profits, and our dollar estimates subtract roughly one to two percentage points from the corporate earnings growth outlook in 2016.
- Corporate earnings growth: Excluding energy and materials, U.S. trailing earnings growth estimates remain decent, at roughly 5%. However, earnings expectations for 2016 (+8%) remain somewhat elevated relative to our forecast for mid-single-digits. A tighter labour market and peak profit margins pose a risk and we expect earnings expectations to be downgraded as the year progresses.
- Valuation: U.S. equities remain quite expensive, which is a headwind to future market performance.
- Business Cycle: We expect the U.S. economy to continue to grow at an above-trend pace in 2016. Fed policy is tightening, but still accommodative in an absolute sense. The economy should be able to chug along with little risk of recession in 2016.
- Sentiment: Equity sentiment is slightly positive but fading back to neutral. Our short- and medium-term oversold signals have faded since the August selloff.
- Conclusion: We continue to have a modest underweight preference for U.S. equities in global portfolios with our earnings outlook supporting a low- to mid-single-digit total return expectation in 2016. Volatility in U.S. equities and rates should remain somewhat elevated into March when the Fed potentially will provide investors with further clarity on the pace of its hiking cycle.
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The Business Cycle Index (BCI) forecasts the strength of economic expansion or recession in the coming months, along with forecasts for other prominent economic measures. Inputs to the model include non-farm payroll, core inflation (without food and energy), the slope of the yield curve, and the yield spreads between Aaa and Baa corporate bonds and between commercial paper and Treasury bills. A different choice of financial and macroeconomic data would affect the resulting business cycle index and forecasts.
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The S&P 500, or the Standard & Poor’s 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
The Russell Eurozone Index measures the performance of the equity markets located in the Euro Zone, based on all investable equity securities in the region.
The Bloomberg U.S. Aggregate Bond Index is a broad based index often used to represent investment grade bonds being traded in United States. It is maintained by Bloomberg.
Bloomberg U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued U.S. Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB-or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding.
Bloomberg U.S. Corporate High Yield Index is an unmanaged index that covers the US dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market.
The MSCI EMU (European Monetary Union) Index is an unmanaged index considered representative of the EMU group of countries.
The S&P/ASX 200 Index tracks the performance of 200 large companies based in Australia.
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2016 Annual Outlook