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Outlook on the United States Summary • We continue to believe that the underlying strength and resilience of the US economy—and the likely duration of the recovery—have been underestimated, even without positive legislative change. • The improved performance of the European and Chinese economies has added to our optimism as we consider the possibility of a synchronized global recovery. • Political upheaval and geopolitical risks are significant short-term drivers of uncertainty for markets, especially given a busy election schedule this year. • We see a wider range of potential scenarios for investors in the future, and we believe this market environment could offer enhanced opportunities for security selection. APR 2017 US equities have generated strong performance over the past eight years, and the gains since the US presidential election have left many investors wondering where equity markets can go from here. On one hand, there may be rising potential for a reversal. The S&P 500 Index rose 33% from its three-year low in February 2016 to hit 2,400—a record—on 1 March. During the latter stages of this rally, sentiment has been high and market volatility low, but expectations for tax cuts and other economic stimulus may have been overly optimistic. On the other hand, US economic fundamentals remain solid and the global economy increasingly appears to be on firmer footing. The International Monetary Fund (IMF), World Bank, and the Organisation for Economic Co-operation and Development (OECD) all forecast stronger global economic growth in 2017, and the global economy might finally enjoy a synchronized recovery for the first time in years. This would add momentum to global corporate profits, which have been buoyed by rising prices. We maintain the view we outlined at the beginning of the year, that the US economy is positioned best among the major economies and that its strength has been underestimated, even without positive legislative change. However, we also see a wider range of potential scenarios for investors in the future on the back of likely changes in domestic and international policies that are difficult to forecast. Overall, we believe this market environment could provide enhanced opportunities for security selection as correlations decline and dispersion increases within and across markets. The Quarter Behind Highlights of the quarter behind include: 1. The US Federal Reserve. The Federal Open Market Committee (FOMC) raised the target fed funds rate by 25 basis points (bps) at its March meeting. Three aspects of the move are worth noting. First, the Summary of Economic Projections (SEP) offered hints that the FOMC voters are coalescing around a common expectation for rates. While the median projection for the future path of rates barely changed from the December meeting—three 25 bp hikes in 2017 and three in 2018—the range of projections tightened, suggesting stronger consensus. Second, in a series of speeches, Chair Janet Yellen, Vice Chair Stanley Fischer, and Governor Lael Brainard telegraphed the move very clearly, suggesting a coordinated effort from the dovish end of the FOMC continuum to steer financial markets in a slightly more hawkish direction. Third, the market response to the speeches and the rate hike was positive, perhaps offering the FOMC validation for its decision and reflecting investor confidence in the strengthened state of the global economy. 2. Political uncertainty. Two months into the Trump presidency, policy uncertainty is still high and new questions have emerged about the GOP’s ability to push forward legislation. Primarily for procedural reasons, Congress prioritized the repeal and replacement of the Affordable Care Act (ACA), but House Republicans suspended this effort due to internal disagreements. While this development may have cooled investor sentiment in some quarters, we believe that, from an equity market perspective, deprioritizing health care reform could be positive. Building support for it in the Senate was likely to be even more difficult than it is in the House, and Congress is now able to focus sooner on corporate tax reform. The experience with health care reform may also diminish prospects for the more controversial and potentially disruptive aspects of the House Republican tax plan, such as the border-adjusted tax. RD12134 2 3. US labor markets. Strong jobs growth, which we consider the best indicator of the health of the US economy, continued. Aided by a relatively warm winter, the monthly change in nonfarm payrolls rebounded from lower readings in the fourth quarter, rising from a three-month average of 148,000 jobs gained per month as of December to 209,000 as of February. By Congressional Budget Office (CBO) estimates, jobs growth in 2016 reduced the number of jobs required to reach full employment from 3.2 million jobs to 1.6 million (Exhibit 1). The CBO forecasts this gap will fully close by the end of 2018, even with a continued rebound in the age-adjusted labor force participation rate. We too are optimistic that the tightening labor market and gradually rising wage growth, which has accelerated from lows of about 1.5% year-on-year to roughly 2.7% more recently, can pull more working-age Americans back into the labor force. The prime age (25–54) labor force participation rate bottomed at 80.6% in September 2015 and has since risen to 81.7% as of February 2017. 4. US household income and wealth. As we have remarked in the past year, one consequence of sustained job growth and the moderate acceleration in wage growth has been a broadening of income gains to US middle class households. Since 2000, the strongest real wage gains have come at the top of the wage scale but, since 2014, individuals in the middle and the bottom have shared in these gains (Exhibit 2). In addition, balance sheets for middle class households are recovering from the crisis. Aggregate US household net worth stood at $92.8 trillion at the end of 2016, 37% above its pre-crisis peak. However, 80% of the wealth increase has been in financial assets, 92% of which are owned by the wealthiest quarter of US households. Middle class wealth is highly concentrated in housing, which has recovered more slowly. At the end of 2016, housing-related wealth stood just 0.7% below its pre-crisis peak (although gains in housing wealth also are not equally distributed). We continue to look for the next leg of the US recovery to be increasingly supported by improvement in middle class prospects. 5. Surveys and sentiment. We are more cautious about interpreting the recent improvement in surveys of consumer and business sentiment. While many surveys have hit cycle highs, politics has likely been an influence, muddying how they might translate to economic activity. The Conference Board’s Consumer Confidence Index hit its highest level since 2000 in March, while the University of Michigan’s Index of Consumer Sentiment and the National Federation of Independent Business (NFIB) Small Business Optimism Index hit their highest levels since 2004 in January 2017. However, the University of Michigan survey’s chief economist has pointed out that “presidential honeymoons” are not uncommon, surveys over the past year have shown deep partisan divides, and sentiment among Republicans and Democrats have moved in opposite directions since the election. We find the global improvement in purchasing manager indices (PMIs) since the first half of 2016 more encouraging (Exhibit 3) and are looking for it to filter through to industrial activity and to capital expenditures. Exhibit 1 The Employment Shortfall Is Projected to Close by End-2018 Employment Shortfalla – Millions of People 10 8 Historical Projected 6 4 2 0 -2 2008 2010 2012 2014 2016 2018 From Labor Force Participation From Unemployment 2020 Total As of 2016 a The employment shortfall is the sum of two components. The first, the employment shortfall from unemployment, is the number of people who are not employed but would be if the unemployment rate equaled its natural rate (the rate arising from all sources except fluctuations in the overall demand for goods and services). That component is projected to be less than zero this year through 2019, reflecting the CBO’s estimate that the unemployment rate will be below its natural rate during that period. The second component, the employment shortfall from labor force participation, is the number of people who are not employed but would be if the rate of labor force participation equaled its potential. Source: Congressional Budget Office, “The Budget and Economic Outlook: 2017 to 2027,” January 2017. Exhibit 2 Real Wage Gains Have Begun to Broaden Cumulative Percent Change in Real Hourly Wages, by Wage Percentile, 2000–2016 (%) 24 16 8 0 -8 19.8 15.7 95th 90th 5.3 5.0 4.8 2.2 70th 10th 50th 30th 2000 2002 2004 2006 2008 2010 2012 2014 2016 As of 2016 Sample based on all workers age 18–64. The xth-percentile wage is the wage at which x% of wage earners earn less and (100 - x)% earn more. Economic Policy Institute analysis of Current Population Survey Outgoing Rotation Group microdata. Source: Economic Policy Institute, “The State of American Wages 2016,” March 2017. Exhibit 3 Global PMIs Have Been Rising since Early 2016 (Index, 50 = neutral) 58 Global Emerging Markets 56 Developed Markets 54 52 50 48 2012 2013 2014 2015 As of February 2017 Source: Haver Analytics, HSBC, J.P. Morgan, Markit 2016 2017 3 The Quarter Ahead Highlights for the quarter ahead include: Exhibit 4 Key Political Risk Events 1. Political and geopolitical risk. As we highlighted in our first-quarter Outlook, we believe global politics and geopolitics present the most significant short-term risks for markets, especially given a busy election schedule in 2017 (Exhibit 4). While the far right and Eurosceptic Freedom Party won just 20 parliamentary seats in the Dutch general election in March 2017, it was never likely to be able to form a government, even with a higher seat total. A greater danger for the euro zone and the European Union (EU), in our view, is the French presidential election in April and May. Opinion polls currently suggest that far right and Eurosceptic candidate Marine Le Pen is likely to make it to a second round run-off but ultimately lose. The election will take place just as negotiations are set to begin for the United Kingdom’s exit from the EU, officially launched when Prime Minister Theresa May triggered Article 50 on 29 March. Half a world away, North Korea has raised significant concerns with recent missile launches, hacking revelations, and the murder of leader Kim Jong-un’s brother. Date Geography Event March 29 UK, EU May triggers Article 50, formally starting 2-year negotiations on EU exit April 6–7 US, China Trump-Xi Summit at Mar-a-Lago April 7–8 Greece, EU EU finance ministers meet, Greece hopes to have a deal in place April 16 Turkey Constitutional referendum April 23 France Presidential election, first round April 28 US Government funding expires April 29 EU, UK EU summit on Article 50 April (TBD) US, China US Treasury publishes semiannual currency report, designates “manipulators” May 2 Germany, Russia Merkel visits Moscow May 7 France Presidential election, second round May 9 South Korea Presidential elections 2. US politics. Many of the uncertainties we raised in our last Outlook remain. There is still little detail on the new administration’s policies and priorities. The setback on health care reform makes it less clear how well the administration will work with Congress and the bureaucracy. Major questions remain about how much opposition the administration will face given the divisive election, the White House’s untraditional methods of communication, and recent news that the presidential campaign is under FBI investigation. Our hope is that the administration responds with a stronger focus on tax reform and not with a more combative approach to trade and international relations. May 25 OPEC OPEC summit May 26–27 G7 G7 summit May (TBD) US Trump publishes full budget May (TBD) NATO NATO summit June 11, 18 France Parliamentary elections End June OPEC Current agreement on production due to expire End June Russia, EU EU sanctions on Russia due to expire July 7–8 G20 G20 summit July Greece Series of payments due, totaling €8.3bn 3. OPEC and oil prices. Following OPEC’s announcement of production cuts on 30 November, spot prices for Brent crude oil rose from roughly $45–$50 per barrel (bbl) to about $55/bbl, before falling back to around $50/bbl in early March. Compliance with the cuts is believed to be relatively high by historical standards, but it has yet to make an obvious impact on oil inventories (Exhibit 5). A variety of factors could be contributing, including: a) production cuts should be felt with a lag, particularly since several major producers increased output in late 2016; and b) refining maintenance season could mean that inventory draws come for refined products first and crude oil later. These effects need to be balanced against: a) the supply response in non-OPEC countries, including the United States, where the Baker Hughes oil drilling rig count hit 652 on 24 March 2017, more than double its low from just ten months earlier; and b) the largest increase ever of “mega-projects” in 2017–2019 according to Goldman Sachs, as projects sanctioned in 2011–2013 come online.1 OPEC is expected to decide whether it will extend its cuts beyond June at its summit on 25 May. It is worth noting that Saudi Arabia likely will want to support the 2018 IPO of Aramco—the national oil and gas company—with higher prices. 4. Inflation. We discuss our views on US consumer price inflation in A Look under the Hood of US Consumer Price Inflation and From Deflation Fears to Inflation Concerns. We continue to believe the United States has seen the lows in inflation and inflation expectations and anticipate that the underlying pressure for higher prices September 24 Germany Federal elections October (TBD) China 19th National Congress, leadership transition TBD General elections by 23 May 2018, likely sooner. Current Parliamentary term ends 15 March 2018 Italy As of 20 March 2017 Source: J.P. Morgan Exhibit 5 Oil Inventories Are Still High OECD Commercial Stocks of Crude Oil and other Liquids Days of Supply 70 60 50 Jan Feb Mar 2011−2015 Range Apr May Jun 2015 Jul 2016 Aug Sep Oct Nov Dec 2017 As of 28 February 2017 Source: Energy Information Administration, “Short-Term Energy Outlook, March 2017,” US Department of Energy 4 will continue to build. However, it is important to recognize that energy prices have had a meaningfully negative and then positive effect on reported inflation rates since 2014 when prices fell from well over $100 per barrel to less than $30. Currently, oil prices are lifting reported inflation as prices are about 35% higher than they were a year ago for West Texas Intermediate crude, but as time passes, the year-on-year change will dissipate if prices remain where they are today. We believe investors should look past the transitory impact of volatile oil prices to see that a broad range of inflationary pressures are growing. 5. Monetary policy. We believe one attraction for the FOMC of hiking rates at its March meeting was that it opened the possibility of moving slightly more rapidly than projected, while remaining in line with market expectations that tightening will only occur at meetings with press conferences: 13–14 June, 19–20 September, and 12–13 December. Indeed, the minutes for the March meeting show that the FOMC anticipates beginning to reduce the size of the Fed’s balance sheet later this year, implying three more moves in 2017: two rate hikes and an announcement regarding its balance sheet. One added motivation for getting all aspects of policy normalization under way before 2018 could be that the composition of the Board of Governors will change. The Board will already be short three of seven members with Daniel Tarullo’s April retirement. Janet Yellen and Stanley Fischer’s terms as Chair and Vice Chair are due to come to an end in February 2018 and June 2018, respectively, and there is some speculation that they may also retire from the Board. Outside of the United States, the recent rise in headline inflation has led to calls for the European Central Bank (ECB) and even the Bank of Japan (BoJ) to consider making their policies less accommodative. We believe it would be unwise for either to begin normalizing policy at this point given that core inflation remains very low. What Is an Investor Supposed to Do Now? March 2017 marks the eighth year since equities bottomed following the global financial crisis. US equities, in particular, have benefited from the subsequent rally, with the S&P 500 Index climbing roughly 250% and the Russell 2000 Index roughly 300%. Many investors have wondered if US equities are poised to decline as margins are near all-time highs and multiples on earnings (which embed those peak margins) are well above historical levels and other markets. We recognize these risk factors but believe that they are excellent reasons why active investment strategies can be a better option than passive, particularly at this point in the market cycle. While we cannot forecast the market level with high confidence in 12 or 24 months, we can focus on identifying companies that we believe exhibit high sustainable profitability and attractive valuations. As it relates to the bigger question of “the market,” much of the recent rally has been driven by valuations, as earnings per share (EPS) growth has been relatively modest (Exhibit 6). Since the US election, the S&P 500 Index has risen roughly 10%, the Russell 2000 Index has risen roughly 14%, and volatility has remained low, despite heightened political uncertainty. The rally in equities also reflects the expectation for significant earnings growth in 2017 and 2018. In 2015 and 2016, S&P 500 Index earnings declined by 1.4% and 0.7%, respectively, as energy and materials companies in particular endured sharp declines in income. Looking forward, S&P 500 Index earnings are expected to increase by 11% in 2017 and 12% in 2018 on the back of the energy earnings recovery and stronger earnings across the rest of the market. Furthermore, as we have pointed out in past Outlooks, it is important to place valuations in context. While the forward P/E ratio for the S&P 500 Index was 18.2x as of 24 March, or 2.9x above its 10-year median, a number of factors suggest that equity markets should be valued more highly than they were in the past: 1. Equities appear more attractive than debt. During this period and the two decades that preceded it, interest rates have progressively fallen in the United States and across the developed world. Even with the recent recovery in yields, the expectation is that they will remain low relative to their pre-crisis level, making equities more attractive on a relative basis (Exhibit 7). Exhibit 6 Valuation Has Driven the Recent Rally S&P 500 Index (100=31 March 2008) 175 Price 150 125 Forward EPS 100 Forward P/E 75 50 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2014 2017 As of 27 March 2017 Source: FactSet Exhibit 7 Equity Appears to Be More Attractive than Debt (%) 10 Recession Recession 8 6 4 2 0 1990 1993 1996 US 10Y Yield 1999 2002 2005 2008 2011 S&P 500 Earnings Yield As of February 2017 Source: Federal Reserve Board, Haver Analytics, Standard & Poor’s 5 2. Profit margins have expanded structurally. For several years, investors have worried that US profit margins have been at or near record highs and could be susceptible to downside. We would argue that there are several factors contributing to the increase in margins. First, there does appear to be a structural uptrend in margins for the S&P 500 Index (Exhibit 8). We believe this reflects the composition of the market as “old economy” companies that typically had lower margins and higher capital intensity fade in importance and are replaced by “new economy” stocks that often have lower capital intensity and higher margins. A good example of this would be the shift in market weight toward technology and, within technology, the shift in weight toward software and services and away from hardware. Another factor could be the sharp fall in the number of listed stocks in the United States since 1996, in part due to robust merger and acquisition activity. As Credit Suisse has noted, “As a consequence of this trend, industries are more concentrated and the average company that has a listed stock is bigger, older, more profitable, and has a higher propensity to disburse cash to shareholders.”2 Finally, Morgan Stanley data shows that mega cap companies, defined as the top 50 stocks by market capitalization, have driven margin expansion since 1996, while margins for smaller companies have remained relatively stable (Exhibit 9). This implies that the largest companies in the United States as measured by market capitalization have succeeded in some combination of a) optimizing their global operations, b) financially engineering their way to higher returns, and/or c) acquiring other companies that could pose a threat to their market position. This also could reflect the shift we described above, which is that two of the largest companies in the world, Apple and Google, are technology companies with high margins that have superseded companies such as ExxonMobil and Wal-Mart, which remain in the top 50 but have much lower profit margins. 3. Corporate balance sheets are in much better condition than they were through much of the past 20 years (Exhibit 10). Firms have taken advantage of record-low interest rates to term out their debt and lower debt servicing costs, reducing the risks of a future recession. Alongside these factors, there are a number of other bear and bull case arguments we could make in terms of valuation and potential remaining upside. There are two sides to most of these arguments, but they generally revolve around the underlying strength of the US and world economies, geopolitical risk factors, upside and downside scenarios around legislation, sentiment and the risk of reversal, as well as monetary policy changes and interest rates. When we take all of these points and counterpoints into consideration, we remain confident that the US equity market continues to have upside. However, we also recognize that there are stocks that appear extended and others that are very attractive, offering opportunities for us to differentiate between future winners and losers. Exhibit 8 Profit Margins Are High, but They Have Risen over Time S&P 500 Index Trailing 12-Month Profit Margin (%) 12 Recession Recession 9 6 3 0 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 As of February 2017 Source: Bloomberg Exhibit 9 Mega Cap Companies Have Driven Margin Expansion Net Margins by Market Capitalization (%) 15 10 5 0 -5 -10 1974 1980 Large 1986 Mega 1992 Mid 1998 Small 2004 2010 2016 Recession As of 2016 Source: updated data originally published in Morgan Stanley, “US Equity Strategy: Will Mega and Large Caps Remain an Inferior Asset Class?”, 20 March 2011 Exhibit 10 Corporate Balance Sheets Are Stronger The US Market Versus Prior Peaks S&P 500 Index Price 27/3/2000 11/10/2007 24/3/2017 1,527.46 1,576.09 2,343.98 Trailing EPS 52.84 84.63 109.21 Trailing P/E 28.90 18.60 21.46 FCF Yield (%) 2.57 2.26 4.72 Net Debt/ EBITDA 4.09 4.51 1.61 206.59 217.11 112.34 10-Year Treasury (%) 6.18 4.64 2.41 Moody’s Baa Bond Yield Index (%) 8.32 6.56 4.62 Total Debt/ Total Equity (%) As of 24 March 2017 Source: Bloomberg 6 Conclusion While it is easy to get caught up in the short-term ups and downs in market psychology, we remain focused on the fundamentals of the global economy and the companies in which we invest. We see a picture that is improving on the back of the broadening recovery in middle class finances and what appears to be a synchronized global recovery. As we indicated in January, we see a wider range of potential outcomes for the economy and markets as a result of the paradigm shift in the US government, but we also believe that investors have focused too much on legislation and not enough on the resilience of this recovery and the strong underpinnings of growth. We recognize that some stocks have likely run ahead of their fair value based on unrealistic expectations—in many cases for policy change where the legislation has not even been drafted. However, we also see many other stocks that have drawn comparatively little investor attention and yet have offered strong returns on capital, solid balance sheets, and attractive valuations. Moreover, the substantial decline in pairwise equity correlations since the US election has opened the door to better security selection opportunities for active managers. Outlook on the United States This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Goldman Sachs, 21 March 2017, “To cut or not to cut, that is the question.” 2 Credit Suisse, “The Incredible Shrinking Universe of US Stocks,” 22 March 2017. Important Information Published on 7 April 2017. The information and opinions presented in this report have been obtained from sources believed by Lazard Asset Management to be reliable. Lazard Asset Management makes no representation as to their accuracy or completeness. 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