Summary of Goldman Sachs 2017 Market Outlook
2017 US Equity Outlook: Democracy in America and the Triumph of Hope over Fear
November 28, 2016
· US equity investors have focused “more on hope than fear” since Donald Trump’s election. Ironically, many commentators believe his campaign rhetoric focused “more on fear than hope.” In 2017, we expect the stock market will be animated by competing views of whether economic policies and actions of President Trump and a Republican Congress instill hope or fear.
· “Hope” will dominate through 1Q 2017 as S&P 500 climbs by 9% to 2400. The inauguration occurs on January 20 and our Washington economist expects much legislation will be proposed during the first 100 days. The prospect of lower corporate taxes, repatriation of overseas cash, reduced regulations, and fiscal stimulus has already led investors to expect positive EPS revisions. Instead of our baseline adjusted EPS growth of 5% to $123, growth could accelerate to 11% and reach $130, which would support a P/E multiple above 18x. Top “Hope” investment recommendations: (1) Cyclicals vs. Defensives; (2) Stocks with high US versus foreign sales exposure; and (3) High tax rate companies.
· “Fear” is likely to pervade during 2H and S&P 500 will end 2017 at 2300, roughly 5% above the current level. Our economists expect inflation will reach the Fed’s 2% target, labor costs will be accelerating at an even faster pace, and policy rates will be 100 bp higher than today. Rising inflation and bond yields typically lead to a falling P/E multiple. Congressional deficit hawks may constrain Mr. Trump’s tax reform plans and the EPS boost investors expect may not materialize. Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in 2H. The median stock trades at the 98th percentile of historical valuation based on an array of metrics. Top “Fear” investment recommendations: (1) Low vs. High labor cost companies; and (2) Strong vs. Weak Balance Sheet stocks.
· Money flow represents a potential upside to our baseline forecast. Equity mutual fund and ETF inflows may benefit as investors lose money owning bonds. After years of active management underperformance and outflows, higher return dispersion will increase the alpha opportunity for investors skilled enough to capture it. Economic policy uncertainty and the later stages of the economic cycle are typically associated with higher stock return dispersion.
DEMOCRACY IN AMERICA AND THE TRIUMPH OF HOPE OVER FEAR
More than 180 years after it was first published, Alexis de Tocqueville’s Democracy in America remains the most insightful analysis of US society and its political economy. Although written in 1835, his description of the presidential elections is timeless: “For a long while before the appointed time has come, the election becomes the important and, so to speak, the all-engrossing topic of discussion. Factional ardor is redoubled, and all the artificial passions which the imagination can create in a happy and peaceful land are agitated and brought to light. . . . As the election draws near, the activity of intrigue and the agitation of the populace increase; the citizens are divided into hostile camps, each of which assumes the name of its favorite candidate; the whole nation glows with feverish excitement; the election is the daily theme of the press, the subject of private conversation, the end of every thought and every action, the sole interest of the present. It is true that as soon as the choice is determined, this ardor is dispelled, calm returns, and the river, which had nearly broken its banks, sinks to its usual level; but who can refrain from astonishment that such a storm should have arisen.” (Alexis de Tocqueville, Democracy in America, originally published 1835).
The words above perfectly characterize the nature of the 2016 election and the unexpected victory of Donald Trump. Another observation of de Tocqueville has particular relevance to our 2017 US equity outlook: “One of the principal vices of the elective system is that it always introduces a certain degree of instability into the internal and external policy of the estate.”
Policy uncertainty introduces a degree of instability to our 2017 forecast that has been absent in recent years. Of course, last year any reference to “policy uncertainty” would have related to the Fed’s own projections that it would raise the funds rate four times during 2016, although as of this writing it has not tightened even one time (but a hike is widely expected on December 14).
Uncertainty always exists when forecasting, but our projections for next year have more elements of instability than usual. Tax reform is widely anticipated but details of any corporate tax cuts are unknown. Policies on the repatriation of foreign earnings are unknown. Specifics regarding any aspect of fiscal stimulus are unknown. President-elect Trump has promised to reduce regulations, but specific policies have not yet been identified.
We expect no policy details will be available until March 2017 at the earliest. Our Washington, DC-based economist Alec Phillips anticipates draft budget resolutions from the House and Senate Budget Committees will be released towards the end of 1Q. These resolutions will show the top-line revenue, spending, and deficit projections for the next 10 years and include reconciliation instructions for the tax-writing and other committees relating to tax reform, infrastructure, and other fiscal issues. (see US Daily: A Fiscal Boost in 2017: How Much, How Fast?, November 17, 2016)
In March or April, our economist expects President Trump will submit a FY 2018 spending bill with detail on tax reform and health care proposals. Between April and July the actual budget resolutions will be debated on the floor of the House and Senate, the tax-writing committees will begin work on detailed legislation, and both chambers will consider the actual tax reform legislation.
In September, the final House/Senate conference report will be enacted before the October 1 start of FY 2018. Note that many of the details of tax reform are likely to change until final agreement is reached. Put simply, enormous tax and fiscal policy uncertainty will exist for almost all of 2017.
Trade is another area of great policy uncertainty. Reflecting on the Great Convention of 1831 relating to the tariff, de Tocqueville wrote: “The question of a tariff or free trade has much agitated the minds of Americans. The tariff was not only the subject of debate as a matter of opinion, but it affected some great material interests of the states.” The issues de Tocqueville identified nearly 200 years ago remain contemporary. The revenue impact on individual companies from potential tariffs, trade barriers, or a border-adjusted tax system will remain unknown until details are released by the new administration.
We end our political discussion on a hopeful note after cautioning investors about the unusual uncertainty surrounding our 2017 forecast. As de Tocqueville observed: “The President is chosen for four years, and he may be re-elected, so that the chances of a future administration may inspire him with hopeful undertakings for the public good and give him the means of carrying them into execution.”
In some ways, the market response to the election of Donald Trump parallels the market’s heightened expectations following the December 2012 election of Shinzo Abe as the Prime Minister of Japan. After years of economic stagnation, Japan finally elected a politician committed to reflating the economy. Investors cheered and the TOPIX rallied by 6% during the ten days between the election and when he took office, and then surged by more than 50% within five months. We expect S&P 500 will rally during the next four months by a relatively modest 9%.
OUR 2017 US EQUITY FORECAST ASSUMES THE FOLLOWING:
1. Earnings. S&P 500 operating EPS will grow by 10% to $116 in 2017 and adjusted EPS will increase by 5% to $123.Investors are excited about a prospective cut in corporate taxes that could boost adjusted EPS to perhaps $130, representing growth of 11%. However, our economists are skeptical that all the anticipated tax cuts will take place given the federal budget deficit constraints. Some tax reform will take place and upside exists to our baseline EPS forecast but it will be less than many investors now expect.
2. Inflation and interest rates. In terms of inflation, core PCE will reach the Fed’s 2% objective by the end of next year. The Fed will hike interest rates next month and three additional times in 2017. Ten-year US Treasury yields will rise to 2.75%.
3. Valuation. S&P 500 currently trades at 19x our forward top-down operating EPS estimate, 18x our forward top-down adjusted EPS and 17x our upside adjusted EPS scenario. The market trades at 17x forward consensus bottom-up adjusted EPS. US equities are highly valued relative to history on most metrics and versus inflation and interest rates. We forecast static valuation during the next 12 months.
4. Path and target. We expect the S&P 500 index will rise to 2400 (+9%) by the end of 1Q as investors embrace the possibility that lower taxes will lead to positive EPS revisions. But less-than-expected tax cuts and higher inflation and interest rates will limit both upward EPS revisions and any P/E multiple expansion. S&P 500 will end next year at 2300, reflecting a price gain of 5% and a total return of 7% including dividends.
5. Buybacks and dividends. Buybacks will rise by 30% as companies repatriate cash held overseas. Dividends will rise by 6% in 2017, above the 4% growth rate currently implied by the dividend swap market.
6. “Hope” vs. “Fear” strategies: “Hope” will dominate during the first part of 2017 as Cyclicals beat Defensives. Firms with high domestic sales will outperform along with companies with high tax rates. “Fear” will dominate later in the year when investors focus on rising inflation and interest rates. Low labor cost and strong balance sheet firms will outperform.
This outlook was authored by GS Global Investment Research team.
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