We believe the fundamental underpinnings for equities remain positive and should support continued gains. Nevertheless, you may wish to temper your clients’ expectations, as returns may be more muted and markets more volatile.
By Ann Holcomb
The general economic backdrop remains constructive, with global growth improving. US economic growth has been sluggish, but a moderate expansion could extend the cycle. Consumer and corporate balance sheets and the housing market are generally healthy. Inflation remains tame for now. Business investment is improving.
Consensus analyst forecasts currently project earnings to remain on a growth path over the next couple of years across many market sectors, particularly technology and health care. However, earnings estimates are elevated, so it may be difficult to achieve upside surprises. The risk of earnings misses is also greater.
However, earnings could be pressured by declining profit margins as interest rates rise and, if labour markets continue to tighten, wage growth accelerates. Further dollar strength could undermine profits for US based multinationals, which would see a decline in the value of their foreign earnings.
While the Federal Reserve is expected to continue raising short-term interest rates in 2018, we believe a gradual pace of tightening will not to pose a big threat to equities as long as economic growth remains moderate. However, if the Fed overshoots or fails to communicate its intentions clearly, volatility could spike.
Higher rates could be more challenging for smaller US companies, which have taken on more debt in this economic cycle. However, corporate balance sheets remain healthy on average, which could enable companies to increase capital spending, fund mergers, and return capital to shareholders.
Some valuation measures – such as free cash flow yields – suggested a more constructive environment for small caps in 2018.
Relative valuations also continue to favour growth sectors over more cyclically sensitive, value-oriented stocks. However, these differences have grown less pronounced following a period of outperformance by growth stocks, led mainly by tech and consumer-related companies.
While market valuations appear relatively full, we believe our fundamental, bottom-up approach to security selection and our long-term investment horizon will enable us to find opportunities in 2018, especially among industries undergoing significant change or trading below their fundamental value.
Potential risks to the 2018 outlook include: a sharper-than-expected rise in interest rates, possible geopolitical shocks, a decline in profit margins and sluggish revenue growth, and political gridlock in Washington. A turn to protectionist trade policies and continued uncertainty about health care are also risks. Given the high level of market optimism and the potential for greater volatility, investors should have realistic expectations.
On balance, we remain optimistic on the outlook for both large and small cap stocks, but suggest a cautious approach given fuller valuations and peak profit margins. If some of the risks on the horizon become magnified, the long-standing bull market may struggle to maintain its momentum. However, bull markets do not die of old age, and if economic and earnings growth are sustained in 2018, further market gains would not be surprising.
As always, we encourage investors to take a long-term view and focus on companies with durable earnings, free cash flow growth, and reasonable valuations. A focus on quality and diversification can help manage risk.
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