UBS House View Weekly
Can US stocks continue to climb?
After rising 12% last year, US equity markets have rallied a further 4-5% this year. But in the wake of a second consecutive year of flat S&P 500 earnings per share (EPS) in 2016, is the recent rise justified by fundamentals?
CIO expects further gains over the next six months and is overweight US equities relative to government bonds in global portfolios. The US profit cycle appears poised to accelerate, and CIO forecasts S&P 500 EPS climbing 11% this year. CIO identifies three key reasons for optimism.
First, the profit cycle is gaining momentum. US GDP expanded 1.5% last year, but the growth trajectory was “back-end” loaded, stronger in the second half than the first. Likewise, corporate earnings growth bottomed in the first quarter and improved in each subsequent quarter.
Fourth-quarter S&P 500 EPS is on track to rise by 7% – the fastest year-over-year pace in more than two years. The quarter’s sales growth of 5% was the strongest since mid-2014, and profit margins stayed high despite a modest uptick in labor compensation.
Earnings look set to sustain their momentum given the improvement in leading economic indicators. The ISM manufacturing, NFIB small business optimism, and consumer confidence indexes have all recently advanced on a 12-month basis, and are currently at or near multi-year highs. Since 1985, 12-month growth in S&P 500 EPS has averaged 14.9% one year after a simultaneous rise in all three gauges.
Second, the drag from low energy prices is reversing. Earnings for the S&P 500 energy sector fell 90% from 2014 to 2016 as oil prices declined from over USD 100 per barrel to as low as USD 26. S&P 500 earnings would have been up by mid-single-digit rates the previous two years had the drag from the energy sector been excluded. But after averaging USD 43 per barrel last year, oil prices, CIO
believes, should hold in the mid-50s range this year, as slower production growth and improving demand balance the oil market. From a depressed base last year of just USD 12bn, energy sector earnings should quadruple this year to USD 45-50bn and add 2-3% to S&P 500 earnings growth.
Third, there is policy-driven upside. CIO’s favorable outlook also rests on the pro-growth aspects of Trump administration policies (corporate tax reform, deregulation, and infrastructure spending), which could boost S&P 500 EPS by 5-15% over the next two years. Potential regulatory reforms in the financial sector should also pave the way for somewhat easier bank-lending conditions, and such conditions have historically preceded accelerating S&P 500 profit growth by nine to 12 months.
There are risks that may prevent US equity gains from continuing. Current valuations of 19x trailing price-to-earnings (P/E) are nearly 20% above the long-term average. But it is not uncommon for US stocks to trade at a premium during periods of low unemployment (4.8% currently versus 6.1% on average since 1960) and low inflation (2.1% versus 3.8% on average). The S&P 500 trailing P/E has averaged 20x in such “investor-friendly” time frames.
Economic momentum, reviving energy sector earnings, and potential profit-boosting policies can lead to a continued earnings recovery. Firming fundamentals suggest the S&P 500’s 4.4% advance this year still has room to run.
Global Chief Investment Officer
Head of Investment Strategy
Wealth Management Americas
The post-election rally in US stocks rests on a solid foundation of improving economic momentum, accelerating earnings growth,
reasonable valuation – especially relative to government bonds – and upside from anticipated pro-growth policy measures.