Market Bulletin. 4Q16 earnings update: Follow the earnings. February 3, In brief. From valuations to earnings

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1 Market Bulletin February 3, Q16 earnings update: Follow the earnings In brief The earnings recession is behind us, and expectations are for robust yearover-year operating earnings growth in 4Q16. Headwinds stemming from the sharp decline in energy prices and strength of the U.S. dollar have dissipated, leading to an earnings recovery in energy and globally exposed sectors. While current earnings growth rates are robust, this should normalize in coming quarters. There are economic and policy risks on the horizon that need to be monitored, as tax policy and wage growth will likely have a significant impact on 2017 earnings. David M. Lebovitz Global Market Strategist From valuations to earnings The beginning of 2017 has seen markets pause and catch their breath after a very strong run into the end of last year. The 6.5% rally following the U.S. presidential election likely pulled forward some returns into 2016, but there is still upside in U.S. equities. However, with multiples having done the heavy lifting thus far, valuation will need to pass the baton to earnings growth as the main driver of returns. 3Q16 saw the first instance of positive year-over-year earnings growth in seven quarters, and based on a combination of analyst estimates and reported results, we expect that this trend continued in the fourth quarter. Jack Manley Market Analyst

2 That said, 3 earnings growth at this stage in the business cycle is unlikely to persist, and as shown in Exhibit 1, estimates are for earnings growth to decelerate, but remain positive, through the end of The broader macroeconomic environment was improving well before the U.S. presidential election last November, and we expect that the upside risk to economic growth created by a Trump presidency should support further gains in corporate profits. However, much like we anticipate wider dispersion of returns in the coming year, we expect a wider range of earnings growth at the sector level as well. For investors, the key will be to follow the earnings. Earnings estimates through 2017 are positive EXHIBIT 1: S&P 500 QUARTERLY OPERATING EARNINGS, Y/Y GROWTH /14 12/14 09/15 06/16 03/17 12/17 Source: Standard & Poor s, J.P. Morgan Asset Management; data are as of January 31, For illustrative purposes only. A solid season thus far The fourth quarter earnings season has brought additional evidence that the earnings recession has officially come to an end. Operating earnings are expected to increase by roughly 26% from a year prior, as the fourth quarter of 2015 marked the local trough in earnings. This makes the year-over-year comparisons easier, but we expect earnings growth will normalize in the mid to high single digits going forward. Looking at individual sectors, one might expect consumer discretionary stocks to do well in an environment of tight labor markets, improving confidence and rising wages. However, we estimate that consumer discretionary sector earnings actually declined in the fourth quarter of last year. This weakness stems from a number of different areas, starting with the fact that discretionary earnings were quite strong in 4Q15, which makes the year-over-year comparison difficult. Weakness in auto earnings due to pension adjustments has also weighed on the sector s earnings. Although the current pullback appears to be more of a mean reversion than the beginning of a downtrend, there are a number of risks worth watching: higher gasoline prices could weigh on discretionary spending and brick and mortar stores remain under pressure as consumers make an increasing number of purchases online. The energy sector is a bit of a mixed picture. While we expect the recovery in energy earnings to continue this quarter, we are seeing a divergence between the performance of oil and gas companies and the equipment and services companies. Oil and gas company earnings are rebounding on the back of a moderation in writedowns and higher oil prices, as the average quarterly price of WTI oil was up 17% in 4Q compared to a year earlier. On the other hand, equipment and services companies are still struggling as excess oil supply has reduced demand for drilling equipment and other oilfield services. This dynamic may change going forward on the back of less regulation or an uptick in infrastructure spending, but the key takeaway from 4Q reports is that the recession in energy earnings is behind us (Exhibit 2). Oil prices have stabilized, removing one key headwind from the earnings equation, but there is a risk of moderate dollar strength in 2017 due to higher interest rates and stronger growth in the U.S. That said, as long as we do not repeat the dollar experience of late 2014 through early 2016, companies with a global footprint should be able to weather the storm. 2 4Q16 EARNINGS UPDATE

3 Energy sector profits are in the midst of a rebound EXHIBIT 2: ENERGY SECTOR CONTRIBUTION TO S&P 500 QUARTERLY OPERATING EARNINGS $4 $3 $2 $1 $0 -$1 -$2 -$3 Source: FactSet, Standard & Poor s, J.P. Morgan Asset Management; data are as of January 31, For illustrative purposes only. Earnings of the more globally exposed sectors have already begun to see a turnaround on the back of a more contained U.S. dollar. Of the 11 GICS sectors, industrials, materials, technology and energy have the highest foreign sales exposure, together generating an average of nearly 54% of sales outside the U.S. in As shown in Exhibit 3, less dollar strength points to a recovery in revenues, and therefore earnings, for these sectors over the coming quarters. Globally exposed sectors benefit from less dollar strength EXHIBIT 3: AVERAGE SALES GROWTH OF GLOBALLY EXPOSED S&P 500 SECTORS VS. BROAD CURRENCIES NOMINAL TRADE-WEIGHTED DOLLAR INDEX '12 '13 '14 '15 '16 '17 High foreign sales (LHS) USD (RHS, inv.) -5 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Source: FactSet, Federal Reserve, Standard & Poor s, J.P. Morgan Asset Management; data are as of January 31, For illustrative purposes only. -15% - -5% 5% 15% Industrial company profits are expected to show some marginal weakness in 4Q, but the devil is in the details. Large, industrial conglomerates have struggled as the final bout of dollar strength works its way through the system, and airline earnings were weighed down by a combination of lower revenue per seat mile an industry metric of unit revenue and a number of one-off charges. That said, aerospace and defense companies should see positive earnings growth, but not enough to push industrial sector profit growth into positive territory. On the other hand, materials tell a more upbeat story. 4Q15 represented the low in earnings for this part of the equity market, as at the time the dollar was approaching its peak, making year-over-year comparisons relatively favorable for companies in this sector. More specifically, metals and mining companies have been a key driver of earnings growth due to higher and more stable commodity prices, as well as a rebound in sales volumes. Finally, the technology sector, which has the highest foreign sales exposure of any S&P 500 sector, is expected to see its second consecutive quarter of positive earnings growth after contracting for the prior three. Services and software providers are projected to do well, and the semiconductor industry should be a solid contributor. Additionally, while the election of Donald Trump may have made some businesses cautious, the improvement in sentiment may have contributed to better-than-expected consumer purchases in 4Q. Turning to the less globally exposed sectors, health care earnings are experiencing some drag from weakness in biotech, but profits for the rest of the sector look healthy. While health care companies have been plagued by headline risk specifically uncertainty surrounding the future of the Affordable Care Act and how drugs will be priced going forward this has not yet become a material drag on profits. Furthermore. J.P. MORGAN ASSET MANAGEMENT 3

4 an aging population suggests that health care should enjoy a demographic tailwind going forward, providing support for earnings despite any adverse changes in policy. Financials are a particularly bright spot and will be a key contributor to earnings growth this quarter, with profits expected to rise by more than 15% from a year prior. Earnings at the majority of the major banks were solid, primarily due to better revenue from capital markets businesses in the wake of the election. Additionally, as shown in Exhibit 4, higher interest rates have provided support for net interest margins, leading to stronger revenues from traditional lending businesses. Net interest margins should rise as Treasury yields increase EXHIBIT 4: NET INTEREST MARGINS AND 10-YEAR U.S. TREASURY YIELD 9% 8% 7% 6% 5% 4% 3% 2% 10-year U.S. Treasury yield, % (LHS) Net interest margins, % (RHS) 1% '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 4.4% 4.2% % 3.6% 3.4% 3.2% % Source: FactSet, FDIC, Federal Reserve, J.P. Morgan Asset Management; data are as of January 31, Net interest margins data is through September 30, For illustrative purposes only. For the utilities sector, we expect decent year-overyear earnings growth, as an unseasonably warm end to 2016 was not quite as warm as the end of Looking at heating degree days, which are the number of degrees that a day s average temperature is below 65 degrees (the temperature below which buildings need to be heated), fourth quarter earnings should benefit from a lower deviation from normal than was the case in 4Q15. Where do we go from here? Equity market returns tend to be driven by three main factors: earnings growth, change in valuation (multiple expansion/contraction) and dividends. Since the election, markets have primarily been driven by a change in valuation, with multiples expanding from 16.3x to 17.1x over the past few months due to speculation about less regulation, stronger economic growth and lower corporate tax rates. While the earnings recession is now behind us, as headwinds from lower energy prices and strength in the U.S. dollar have finally begun to abate, there are some potential macroeconomic developments that bear watching. An unemployment rate below 5% signals that the labor market is at, or very close to, full employment, and it is becoming increasingly probable that wage growth will accelerate over the coming months. Wage growth is not a headwind for profits if it is offset by stronger revenue growth, as this allows companies to preserve their profit margins. However, if wage growth causes profit margins to deteriorate, the increase in consumer incomes can erode corporate profitability. Accelerating economic growth could translate into stronger revenues EXHIBIT 5: S&P 500 Y/Y SALES GROWTH VS. NOMINAL U.S. GDP Y/Y GROWTH S&P 500 sales y/y growth, % (LHS) 5% U.S. GDP y/y growth, % (RHS) 15% 3% 5% -5% - -15% '02 '04 '06 '08 '10 '12 '14 '16 Source: BEA, FactSet, J.P. Morgan Asset Management; data are as of January 31, For illustrative purposes only. 1% -1% -3% -5% 4 4Q16 EARNINGS UPDATE

5 The new administration seems focused on implementing a more pro-growth agenda than we have seen in recent years, which suggests that both economic growth and inflation could accelerate from the tepid pace observed on average during this expansion. As shown in Exhibit 5, there is a close relationship between nominal economic growth and S&P 500 revenue growth, suggesting that accelerating economic growth could translate into stronger revenues. Additionally, it looks like companies may be regaining pricing power. According to the most recent NFIB small business survey, after a nearly year-and-a-halflong period when the number of companies planning to increase prices was in line with the number of companies planning to increase wages (and therefore no pricing power), company plans to increase prices have shot higher, pointing to an increase in pricing power this year (Exhibit 6). The spike in the ISM prices paid index reaffirms this message corporate pricing power is coming back, and should help companies to protect their margins. Corporate pricing power is returning EXHIBIT 6: NFIB SMALL BUSINESS SURVEY, PRICE PLANS VS. COMPENSATION PLANS IN NEXT 3 MONTHS 30 Price plans in the next 3 months Compensation plans in the next 3 months '09 '10 '11 '12 '13 '14 '15 '16 Source: FactSet, NFIB, J.P. Morgan Asset Management; data are as of January 17, For illustrative purposes only. Accelerating economic growth along with the return of pricing power should lead to stronger sales growth for S&P 500 companies, allowing them to offset any increase in wages. Furthermore, Standard & Poor s estimates that a reduction in the corporate tax rate could add $10 to 2017 earnings per share. The question is what this change in tax policy will look like. There are essentially three policy options: a revenue neutral tax cut, a straight reduction in tax rates and a tax cut with border adjustments federal tax revenues came in at about $300bn, or 1.6% of GDP. A revenue neutral tax cut would not materially change that figure, nor would it help businesses. On the other hand, a flat out reduction in the corporate tax rate would boost corporate profits as mentioned above, but does not seem like a terribly likely outcome. Finally, a destination-based cash flow tax (i.e. border adjustability) would benefit exporters at the expense of importers, favoring aircraft, motion picture and services companies, while hurting refiners, apparel and oil and gas extraction companies. Some carve outs under the third scenario are possible, but at the current juncture, it is not clear what those carve outs may be; initial proposals have been to exempt raw materials and intermediate goods, products for which no U.S. source exists or low dollar value items. Finally, there is one big assumption behind all of this: that there is no retaliatory response from other countries if the U.S. begins to apply tariffs on foreign imports. As we have said time and time again, a tariff for a tariff makes the whole world poor. The evolution of tax policy will be a key driver of corporate profits, and equity returns, in Investment implications While the 2017 earnings picture is fairly optimistic, there is clearly room for disappointment. Many of the proposed policies will undoubtedly be met with J.P. MORGAN ASSET MANAGEMENT 5

6 resistance, and there is a risk that even if economic growth does accelerate, it may fail to make its way to the bottom line earnings estimates currently point to 10.9% growth in the coming year, an outlook that may be too optimistic (Exhibit 7) earnings growth estimates may be too optimistic EXHIBIT 7: S&P OPERATING EARNINGS PER SHARE, Y/Y GROWTH ESTIMATES % % % est.: 10.9% 10.5% Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Source: FactSet, FDIC, Federal Reserve, J.P. Morgan Asset Management; data are as of January 31, For illustrative purposes only. However, the combination of diminished headwinds from low energy prices and a rising dollar, an improving economic backdrop and the return of corporate pricing power suggests that companies should be able to deal with the coming increase in wages, and a corporate tax cut could be the icing on the cake. We expect mid to high single digit profit growth with risks tilted to the upside in 2017, and believe that this dynamic will provide fundamental support for U.S. equity markets to gradually move higher over the course of the year. 6 4Q16 EARNINGS UPDATE

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