Global Investment Strategy Global Equity Strategy Report April 26, 2017 Stuart Freeman, CFA Co-Head of Global Equity Strategy Scott Wren Senior Global Equity Strategist Analysis and outlook for the equity market» Although it is early in the earnings reporting season, a favorable 74 percent of S&P 500 Index companies have reported earnings that are ahead of expectations (to date).» With roughly 20 percent of S&P 500 Index companies having reported, earnings are showing growth that exceeds 10 percent on revenue growth of roughly six percent versus the first quarter of 2016.» Thus far, results are being driven by Energy, Information Technology, and Financial sector earnings gains. What it may mean for investors» We believe that investors should capitalize upon any pullbacks in the domestic equity market to acquire cyclically sensitive stocks. Large Cap Mid Cap Developed- Market Emerging-Market Small Cap Underweight Very Early Look at the U.S. Earnings Scene While it is still early in the first-quarter earnings reporting season, the full-year 2017 earnings estimates from individual company analysts have declined from roughly $134 to $129.83 in recent quarters. We believe that consensus expectations are likely to soften further through the year as moderate gross domestic product (GDP) growth and extended margins keep somewhat of a lid on the earnings-growth rate. At this early stage of the year, our current S&P 500 Index earnings target for 2017 is $127. Thus far, first-quarter S&P 500 Index earnings (versus the first quarter of 2016) have risen by approximately 10 percent. Table 1 shows the quarter-over-quarter earnings change by sector. Earnings from the Energy, Financials, and Information Technology sectors offer particularly strong comparisons, while other sectors are showing lower-single-digit increases, and four of 11 sectors show negative comparisons. In each of the very strong cases, the year-ago earnings represented an easy comparison. As we move through the year, we expect that Energy-sector comparisons generally will remain favorable (unless energy prices take another material downward dip). We expect mid-year 2017 Financial-sector comparisons to become somewhat more difficult, but they should fare better later in the year as loan growth continues, and with slightly higher net interest margins expected for later this year. While we 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 7
expect Information Technology-sector comparisons to become tougher through this year, we expect that consumer and business spending will continue to favorably impact the Technology, Consumer Discretionary, and Industrial sectors. As the developed international economies show more signs of growth this year, we also expect rising international demand for these domestic sectors. Table 1. First Quarter 2017 S&P 500 Index Sector Earnings (to Date) versus First Quarter 2016 Sector Quarter over Quarter Change in Earnings Energy $2.72 versus a loss of $0.35 Financials +17.9% Information Technology +17.9% Materials +15.4% Real Estate +4.8% Consumer Staples +2.4% Health Care +1.8% Utilities -2.2% Industrials -3.2% Consumer Discretionary -3.9% Telecommunication Services -4.7% Sources: S&P Global Market Intelligence, Wells Fargo Investment Institute, 4/24/17. With only a handful of companies having reported for the first quarter, roughly 74 percent of those firms have generated earnings ahead of expectations. We haven t seen outperformance of this magnitude since the third quarter of 2014. Only 19.5 percent of companies have reported results below expectations (we did witness a 17.6 percent underperformance rate in the first quarter of 2016 and 19.4 percent in the fourth quarter of 2015). We would expect the percentage of outperformers to moderate as the balance of companies report their first-quarter earnings results. Chart 1. Outperforming versus Underperforming S&P 500 Index Earnings Reports: 1992 to Present 90 80 Percentage Outperforming/Underperforming 70 60 50 40 30 20 10 0 Positive Surprises Negative Surprises Median Positive Median Negative Sources: Bloomberg, Wells Fargo Investment Institute, 4/24/17. Chart shows the percentage of S&P 500 Index positive earnings surprises and negative earnings surprises (versus analyst expectations), along with the median for each measure. 2017 Wells Fargo Investment Institute. All rights reserved. Page 2 of 7
We have plotted the percentage of outperforming versus underperforming earnings reports for S&P 500 Index companies from the first quarter of 1992 through the first quarter of 2017 in Chart 1. The ratio of outperformers to underperformers (thus far) is 3.8:1, which is high versus an average ratio of 2.9:1 from the second quarter of 1992 through the first quarter of 2017. While the ratio of earnings beats currently is high, investors must keep in mind that S&P 500 Index earnings last year were flat versus the prior year. It also is important to keep in mind that, some months ago, many investors were looking for even larger outperformance for this year than they are today. Our S&P 500 Index earnings estimate of $127 for 2017 would result in an increase of roughly eight percent, overall, for earnings this year (versus 2016 earnings). However, investors should remember that risks remain. Valuations for the S&P 500 Index, the Russell Midcap Index, and the Russell 2000 Index of smallcap companies remain above (or well above) their 20-year medians. The trailing 12-month S&P 500 Index price/earnings (P/E) valuation has increased from 14x in 2011 to 21x today. Valuation increases have represented a meaningful portion of returns over that time frame. While higher valuations, on their own, do not end economic cycles, they are likely to increase volatility levels. Policy uncertainties (and risks) remain both to the downside and the upside, including Federal Reserve (Fed) policy risks and U.S. fiscal policies. Geopolitical risks appear to have increased in recent months as various countries are testing the new U.S. political regime. Typically, during periods of Fed rate increases, P/E valuations can drift lower even as earnings continue to expand. We believe that investors should capitalize upon pullbacks in this market, should they occur. In our view, we are still in the seventh inning of this cycle, and investors should accumulate cyclically sensitive stocks that can benefit from the balance of the economic cycle. We believe that favorable earnings growth should continue through this year and into 2018. Weekly Wrap and Look Ahead All major domestic and international indices were positive year to date; most were positive last week. Index 1 Last Week s Performance 2017 YTD Performance S&P 500 +0.9% +4.9% DJIA -0.5% +4.0% NASDAQ +1.8% +9.8% Russell 2000 +2.6% +1.7% MSCI EAFE +0.2% +5.6% MSCI Emerging Markets +0.1% +11.5% 1 For the week of April 17 April 21, 2017 Sources: Wells Fargo Investment Institute, Bloomberg, 4/24/17 Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. 2017 Wells Fargo Investment Institute. All rights reserved. Page 3 of 7
Five of 11 S&P 500 Index sectors outperformed the index, and eight of 11 gained ground on the week. Best-Performing Sectors Last Week s 2 Performance Worst-Performing Sectors Industrials +2.0% Energy -2.1% Consumer Discretionary +1.9% Telecom Services -1.6% Information Technology +1.8% Health Care -0.4% 2 For the week of April 17 April 21, 2017 Source: Wells Fargo Investment Institute, 4/24/17. Past performance is no guarantee of future results. Last Week s 2 Performance Stocks reacted positively to the first round of French elections and to talk of tax reform both globally and here in the United States. We do not believe that the outcome of the May 7 French presidential runoff will affect the domestic or global economy to any meaningful extent. We suggest that U.S. equity investors pay the most attention to the domestic fundamentals and where they are headed. We continue to argue that U.S. economic fundamentals in 2017 likely will have very little to do with Congress or the new administration. The equity market, of course, is looking ahead and trying to determine what, if any, pro-growth proposals from President Trump and his team actually will be implemented. We believe the proposals that are eventually implemented in Washington will be more of a 2018, 2019 and 2020 story. The modest growth/modest inflation environment we have been living with for the past eight years likely will last well into 2018. Next year, U.S. economic growth may pick up a touch based on our very preliminary analysis. We anticipate some stock headwinds from wage gains as investors fret over potential margin deterioration in a domestic economy that is only accelerating to a minor degree. Sector S&P Weighting* Wells Fargo Investment Institute Guidance Consumer Discretionary 12.4% Overweight 14.9% Consumer Staples 9.4% Underweight 5.5% Energy 6.4% Underweight 4.0% Financials 14.2% Overweight 16.4% Health Care 13.8% Overweight 17.2% Industrials 10.2% Overweight 11.6% Information Technology 22.3% 21.8% Materials 2.8% 3.0% Real Estate 2.9% 3.1% Telecom Services 2.3% 2.5% Utilities 3.2% Underweight 0.0% S&P 500 Earnings Estimate for 2017 $127.00 S&P 500 Year-end 2017 Target Range 2230-2330 *Sector weightings may not add to 100% due to rounding. Weightings as of 4/24/17. Targets are not guaranteed and may change. Sources: Wells Fargo Investment Institute, Bloomberg, 4/24/17. 2017 Wells Fargo Investment Institute. All rights reserved. Page 4 of 7
S&P 500 Index Sectors: Wells Fargo Investment Institute First-Quarter 2017 Earnings Estimate Consumer Discretionary Consumer Staples 3.6 Percentage Change Y-o-Y (Est.) -2.5 Energy NA (+$3.20 est. vs. -$0.35 in the first quarter of 2016) Financials 15.0 Health Care 0.0 Industrials -4.5 Information Technology 14.0 Materials 14.0 Real Estate 4.5 Telecommunications Services -3.0 Utilities -2.0 S&P 500 Index 7.8% Sources: Wells Fargo Investment Institute, S&P Capital IQ, 4/17/17. Wells Fargo Investment Institute estimates were established prior to the start of first quarter 2017 earnings reporting season. Valuations and Fundamentals for Five Primary Equity Asset Classes Valuations S&P 500 Index Developed Markets Russell Midcap Russell 2000 Emerging Markets P/E (based upon 2017E EPS) 18.7 15.5 20.7 29.1 13.2 Price/Book Value 3.1 1.7 2.8 2.1 1.7 EV*/Sales 2.4 1.5 2.3 1.8 1.7 EV*/EBIT 18.6 16.9 24.3 34.8 14.4 EV*/EBITDA 13.0 10.1 14.7 17.0 9.4 Dividend Yield (%) 2.0 3.1 1.7 1.4 2.4 Profitability S&P 500 Index Developed Markets Russell Midcap Russell 2000 Emerging Markets Gross Margin (%) 33.3 29.4 31.8 28.8 24.3 Operating Margin (%) 12.7 9.0 9.5 5.3 11.6 Profit Margin (%) 8.9 5.5 4.7 1.5 8.5 Return on Assets (%) 2.8 1.0 1.8 0.6 2.0 Return on Common Equity (%) 13.2 7.8 7.7 2.5 11.1 Return on Capital (%) 7.0 3.3 4.6 2.8 6.1 Dividend Payout Ratio 53.4 65.9 70.6 71.9 34.2 Sales Per Employee ($) 840,562.9 694,716.5 1,007,118.8 1,487,779.1 577,047.9 Balance Sheet S&P 500 Index Developed Markets Russell Midcap Russell 2000 Emerging Markets Current Ratio 1.4 1.2 1.4 1.8 1.3 Net Debt to EBITDA 1.5 3.0 3.5 4.4 1.6 Total Debt to EV* 0.3 0.8 0.3 0.4 0.5 Total Debt to Total Equity (x100) 114.1 156.3 106.4 110.2 104.0 Total Debt to Total Assets (x100) 24.9 22.1 26.8 26.6 21.5 Market Capitalization S&P 500 Index Developed Markets Russell Midcap Russell 2000 Emerging Markets Last Index Level ($) 2,373.7 1,780.8 1,882.3 1,397.9 961.8 Total Market Capitalization ($mil) 20,996,052.0 16,779,964.0 6,993,655.5 2,248,829.3 8,504,023.0 Free Float Market Cap. ($mil) 19,850,206.0 13,078,402.0 6,410,687.0 1,933,975.0 4,741,296.0 *EV = Enterprise Value. EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization. 2017E EPS = 2017 estimate earnings-per-share Sources: Wells Fargo Investment Institute, Bloomberg, 4/24/17. Developed Markets: MSCI EAFE Index (Europe, Australasia, Far East). Emerging Markets: MSCI Emerging Markets Index. 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 7
Risk Factors Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities The prices of small and mid-cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. Definitions An index is unmanaged and not available for direct investment. DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. NASDAQ is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index. Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity mark Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25 percent of the total market capitalization of the Russell 1000 Index. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment. Disclaimers Global Investment Strategy ( GIS ) is a division of Wells Fargo Investment Institute, Inc. ( WFII ). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. The information in this report was prepared by the GIS division of WFII. Opinions represent GIS opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. 2017 Wells Fargo Investment Institute. All rights reserved. Page 6 of 7
Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0417-04606 2017 Wells Fargo Investment Institute. All rights reserved. Page 7 of 7