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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.
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Published on 7 April 2017.
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