Checking the Transmission

Transcription

1 Fundamental Equity 2nd Quarter 2017 Global Equity Outlook Checking the Transmission Last quarter, we shared our view that the change in the US administration could lead to progrowth policies with significant implications for equity investors (1Q2017 Global Equity Outlook: From Low Growth to Pro-Growth). Since then, optimism on the economy has indeed soared, but we believe it needs to be converted into confidence to ignite corporate animal spirits. In this quarterly outlook, we explore transmission mechanisms, potential headwinds, and mileposts that may indicate this transition is underway. We maintain a positive outlook for equities based on earnings growth. Global growth and earnings forecasts are trending upward in all major regions for the first time since US equities have reached all-time highs and valuations are expensive in many regions globally, reflecting investor and business optimism about the potential for pro-growth policies that could support further economic and earnings growth (p. 2). Optimism now needs to convert to confidence in order to turn sentiment into action, generating real business activity and maintaining investor enthusiasm. We think deregulation and tax reform are critical components of this transition. Regulatory reform is easier to enact because it can largely be accomplished with executive orders. Tax reform may be more challenging, but we think it is the key to reviving confidence (p. 3). Political uncertainty remains a risk to this transition process. In the US, we think the failure to pass healthcare reform (to date) has increased the risks around the administration s ability to execute on other elements of its pro-growth agenda. European political risk remains elevated, but may actually be receding, given the results of recent elections in the Netherlands and France. Polls in France indicate that Emmanuel Macron is likely to defeat the nationalist candidate Marine Le Pen in the second round election on May 7 (p. 4). Signs we will be watching to gauge whether the conversion to confidence is successful include rising corporate investment and earnings growth meeting or exceeding forecasts. We believe it is important to see fundamentals catch up to expectations, particularly given today s full equity valuations (p. 5). We maintain most of our regional and sector views from last quarter, based on our core expectation of stronger global growth. We are still positive on the US but recognize that legislative challenges could slow the pace of pro-growth policy implementation. We are more bullish on Europe than last quarter due to earnings upgrades and potentially receding political risk. We continue to believe economic momentum will support EM equities, and remain optimistic on corporate fundamentals in Japan (p.6). will be achieved. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this presentation. Diversification does not protect an investor from market risk and does not ensure a profit. Past correlations are not indicative of future correlations, which may vary.

2 Earnings Growth Can Drive Equity Prices Higher We continue to believe pro-growth policy from the US will support further economic recovery and equity performance globally. Global growth has already seen a pickup, with many regions contributing positively. Although momentum could slow due to less accommodative monetary policy, political uncertainty and the waning effects of China s fiscal stimulus, the current level of growth is robust. Our Global Current Activity Index (CAI), which measures growth signals from major high-frequency indicators, is consistent with growth of just over 4% (see our 2Q2017 Global Fixed Income Outlook: Seeking Equilibrium). This is a positive backdrop for revenue and earnings growth, and global earnings are being revised upward. For the first time since 2010, consensus earnings forecasts point to positive growth in all major global regions. Global earnings forecasts are being revised upward and are positive for all major global regions the first time since 2010 MSCI All-Country World consensus EPS growth (%) Annual EPS growth (%, consensus forecast for 2017) EM Europe ex UK Japan US UK E Source: Left Exhibit: IBES via Datastream, as of April 19, 2017, Right Exhibit: Factset, as of April 25, 2017 using MSCI EM index for Emerging Markets, MSCI Europe ex UK index for Europe ex UK, Topix index for Japan, S&P 500 index for US and MSCI UK index for UK. We continue to believe that correlations between stocks will trend lower while the dispersion of returns increases, both of which are constructive for active management. S&P 500 correlation has already declined to below the historical average. As trade and economic policies become clear, they will impact sectors and companies differently based on their supply chains, capital structures and geographical exposures. We expect this differentiation in fundamentals to create winners and losers, further increasing the dispersion of stock returns. We believe active managers are best-positioned to benefit in this environment. Correlations between stocks have been falling, creating more stock picking opportunities S&P month stock correlation (%) Historical average (from 1990) 20 10% Source: Goldman Sachs, as of March Goldman Sachs Asset Management

3 Optimism Needs to Convert to Confidence Global equity markets are higher now than before the US election last November, reflecting optimism about economic and earnings growth. However, this pervasive optimism needs to be converted to corporate confidence in order to ignite animal spirits, sustain business activity and maintain investor enthusiasm. Business confidence and the accompanying boost in economic activity are important given the expensive equity valuations in many developed markets. We believe that deregulation and tax reform could be the catalysts to this transition. Reducing regulation Compared to tax reform, deregulation is less subject to legislative gridlock and can be more easily accomplished through the Executive branch of government. We expect deregulation to be concentrated in specific areas based on the Administration s statements and actions (see 2017 GSAM Investment Outlook, Sector Specific Announcements ). Deregulation may have the most immediate impact in the energy and banking industries. In energy, we are constructive on federally-regulated midstream pipeline companies. Energy Infrastructure is likely to be a key area of focus for the Administration, since policy changes can be made entirely through Executive orders, enabling a quick turnaround. President Trump s Executive orders on the Dakota Access and Keystone pipelines immediately after taking office hint at the Administration s desire for a more pro-business and less onerous regulatory environment. Banks could benefit from the potential for clearer regulations and a more moderate stance from regulators in the future, although policy uncertainty remains high. President Trump is expected to nominate Randal Quarles to be the head Federal Reserve banking regulator. Quarles is widely considered to be more balanced and less hawkish than other candidates, which could signal a swing of the regulatory pendulum. Taxes and regulations are key concerns of small US businesses NFIB Single Most Important Problem survey Other* 26% Taxes 20% Competition from Large Businesses 9% Regulation and Red Tape 17% Poor Sales 12% Quality of Labor 16% Source: NFIB, as of March * Other cateogry includes: cost and availability of insurance (8%), cost of labor (6%), financing and interest rates (2%), inflation (1%), and other (9%) Goldman Sachs Asset Management 3

4 Tackling tax reform Tax reform is possibly the most critical policy lever to successfully unleash corporate animal spirits. Taxes remain the top concern for small businesses in the US 1, indicating that tax reform is much desired. The likelihood of a revenue-neutral tax reform has declined meaningfully following the failed repeal of the Affordable Care Act (ACA). It is also unlikely that the proposed Border Adjusted Tax (BAT) will be implemented successfully. We believe a tax cut is now more likely than profound tax code reform, but the cut may not be to as low as the 20% rate proposed by the Republican House blueprint. We also believe Congressional approval of the 15% tax rate proposed in the White House tax plan is highly improbable, as it would increase the Federal deficit by $2.4 trillion over the next decade. 2 Political Uncertainty: Speedbump or Roadblock? Converting optimism to confidence means turning sentiment into action. In the US, this is proving more challenging than many politicians, investors and voters had originally thought. Gridlock alert for Washington Republican control of the White House and Congress is being offset by significant and powerful factions within the party. The failure to repeal and replace the Affordable Care Act (ACA) was surprising and has implications well beyond healthcare: waning confidence and a loss of momentum could further hamper the administration s ability to make other major changes, such as reforming the tax code or trade policy. Further complicating the issue of a fractured Republican party, Democrats are mounting a more forceful opposition than in previous terms, particularly as measured by the amount of no-votes for candidates that require Congressional confirmation. Even changes that were expected to result from executive action or regulatory relief are stalled, since the Trump administration is months behind in filling staff positions compared to previous administrations. Speed limit for populism in Europe European political risk also remains elevated but may be starting to recede, which should be positive for financial markets. Momentum for the far right across Europe may be slowing: the Dutch far-right party did not win a majority of parliamentary seats, as had been expected, and Germany s far-right party has been losing mainstream support. In France, polls indicate that Emmanuel Macron is likely to defeat the nationalist candidate Marine Le Pen in the second-round election on May 7. Should Macron win, we expect French policy to remain broadly consistent with existing policy given Macron s tenure as Economy Minister under the current French President François Hollande. British Prime Minister Teresa May s decision to call a snap election on June 8 introduces an additional event to watch, but we believe it is likely to result in a confirmation of support for May and her vision to execute on a hard Brexit. 1 NFIB Single Most Important Problem survey, as of March Capital Economics, Trump s new tax plan looks a lot like the old one, April 26, Goldman Sachs Asset Management

5 Mileposts Signaling Increasing Confidence We believe the most significant signs that optimism is successfully transitioning to confidence will be a resurgence of corporate investment and earnings growth. Increasing corporate investment Business investment remains depressed in the US. Non-residential private investment saw no growth throughout 2016, although there has been some rebound in 1Q Progress on tax reform and deregulation could create a more business-friendly environment in the US, sparking a resurgence of domestic capex, particularly as China s investment boom fades. In addition, more clarity on policy and its continuity whether it will be a two-year, four-year or eight-year regime will help sustain the corporate confidence necessary for long-term investment decisions. Business investment has been lacklustre in the US through 2016, despite some rebound in Q Year-over-Year change in US non-residential private investment (%) Source: BEA, Haver, GSAM, as of Q Investment in industrial automation is an area of focus for us globally, as we view it as a potential catalyst for renewed productivity growth, more competitive costs of goods sold and improved product quality. Global automation penetration is still very low and further investment in automation could have a variety of benefits: the US could increase its manufacturing competitiveness by reducing labor costs, which are currently very high by global standards, while China and other Emerging Market (EM) countries could help stem rising wage costs. While this could create challenges on the employment front and displaced workers would require training to gain additional skills, it would also be supportive for economic growth. Earnings growth meeting or exceeding forecasts Earnings growth forecasts have been optimistic, reflecting the potential for pro-growth US policies as well as solid economic growth. Now fundamentals need to catch up with sentiment. A recordhigh US equity market and full equity valuations compared to history in many regions of the world indicate that considerable optimism is already priced into markets. Realized earnings growth must now measure up to these expectations in order sustain this investor enthusiasm and equity performance. The revival of animal spirits and real economic growth are critical for ultimately boosting revenue and earnings growth. Strong earnings growth, therefore, will suggest that the transmission to confidence is succeeding. The early earnings results in the US and Europe have provided encouraging signs of growth. In addition, there has been a significant up-tick in short-cycle business activity across a broad cross section of companies. We continue to closely watch the global earnings season for signs of strength as it progresses. 3 BEA, Haver, GSAM, as of Q1 2017, based on quarterly year-over-year growth. Goldman Sachs Asset Management 5

6 6 Goldman Sachs Asset Management Updates to Our Views Most of our core views from the last FESG outlook (1Q2017 Global Equity Outlook: From Low Growth to Pro-Growth) remain intact, given our expectation that pro-growth policy in the US will enable stronger US and global growth. We continue to analyze potential political and policy changes, as well as market reactions, and update our views accordingly. US: we are still positive but recognize that legislative challenges could moderate the pace of policy change and growth. The US economy continues to offer the strongest growth amongst the developed countries, though this is reflected in equity valuations The S&P 500 index is currently trading at a 12-month forward price-to-earnings (P/E) multiple of 17.6x, putting it in the 99th percentile relative to its own 10-year history. 4 Europe: we are more bullish than last quarter as earnings forecasts are being upgraded and political risk may be receding. We have long held the view that an earnings recovery had the greatest potential to drive European equities higher, since European earnings remain depressed post-financial crisis and European companies have high operational leverage. Finally this year, earnings estimates are being revised upwards, as opposed to downwards, on average, in previous years. Three key end markets are driving the earnings upgrades: 1) the domestic economy, which represents about 50% of European corporate revenue exposure, is improving; 2) the US economy (roughly 20% of revenues) is strong; and 3) many EM economies (roughly 20% of revenues) are stabilizing or recovering. 5 Valuations have risen, with the MSCI Europe index trading at a 12-month forward P/E multiple of 15.3x 4, but remain below that of the US market. Japan: we are positive on Japan based on strong corporate fundamentals. Corporate reforms are bringing about structural and behavioral changes and record high cash levels are leading to rising shareholder returns. In addition, the macro data continues to show improvement, with robust consumption and business sentiment. The tight labor market is a potential headwind, with rising labor costs becoming an increasing concern for companies. EM: we believe positive economic momentum will continue to support earnings growth and equities. EM equities have already rallied on the commodity price recovery and increasing sentiment that the protectionist rhetoric from Trump on trade will not be converted into actual policy. Equity valuations have been rising but are still attractive versus developed markets; the MSCI EM index is trading at a 12-month forward P/E of 12.3x, a 25% discount to the MSCI World index. 4 Despite the fundamental earnings recovery, EM remains subject to several external risks including rising interest rates and increasing geopolitical tensions (Please see our April Emerging Markets Equity Viewpoints for individual country outlooks). Banks: we remain positive on banks, given their potential to benefit from lighter regulation, lower taxes (in the US), higher interest rates and a steeper yield curve. Valuations are still attractive after stocks have pulled back following the initial run-up after the US election. In Europe, we are encouraged by the successful clean-up of the banking system that included capital-raising and nationalization of the remaining troubled banks. We also note that bank loan supply is growing to meet increasing demand. Healthcare: we expect many cross-currents within the sector given the uncertainty around future administrative action. We believe the sector will benefit overall from being able to maintain the same insured populations, though it faces many crosscurrents. An overhaul of the FDA regulatory process could accelerate and streamline drug approvals while reducing associated costs, benefitting Pharmaceutical and Biotechnology companies. On the other hand, these companies face continued headwinds from political pressure on drug pricing and increased competition from generics. 4 Factset, as of April 25, Factset, using MSCI Europe index, as of April 2017.

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