U.S. Equities: Will Modest Growth and Higher Rates Translate into Strong Returns?

U.S. equities are likely to remain turbulent but, in our view, have the potential to advance on sturdy economic fundamentals and a still-accommodative monetary policy.

More than six years into the current secular bull market, U.S. stocks are now facing multiple challenges tied to rate hikes, China, oil prices and the strong dollar. In many ways, economic prospects appear strong, with the consumer (two-thirds of economic activity) leading the way. After a dip at mid-year, U.S. consumer confidence has rebounded, supported by low gas prices and an improving labor market. Home price appreciation remains in positive territory. Unemployment has continued to trend downward, reaching 5.0% through November, when payrolls rose at a healthy pace as well.

The backdrop is less compelling in the industrial sector, which continues to face competitive headwinds from the strong dollar, economic uncertainties and contraction in the commodity sector. Multinational companies have been affected by the dollar translation of foreign earnings. And the energy sector continues to reel from sustained sub-$50 oil as OPEC continues pumping at high levels, even as production growth in the U.S. slows.

Reasonable Growth, Murky Earnings Picture

We believe that the U.S. will continue to display reasonable growth given the strength of the consumer and the Fed's cautious approach to raising rates. Inflation shows little sign of heating up, as benign employment statistics haven't translated (thus far) into wage pressures while input costs remain low. Earnings prospects are cloudy. While cheap labor, low wages, low oil prices and multiple cost-cutting efficiencies have lifted profit margins to record levels, we see little on the horizon that would drive them up further and much that could pressure them downward-including reversals of the trends just mentioned and continued strength in the dollar. Overall, we believe that operating earnings for the S&P 500 could grow around 5%-7%, augmented modestly by the reduced share count associated with buybacks. Among the market segments we think could prove interesting in 2016 are companies with a more domestic focus (often small- or mid-cap names), and consumer-oriented companies, although the latter face the potential for disruptive influence of technology and an increasingly discerning consumer. Finally, we anticipate that the currently healthy mergers and acquisitions market will extend into 2016 as larger companies continue to use M&A for growth.

U.S. Companies Expected to Show Modest Earnings Growth

S&P 500 Index and Earnings

S&P 500 Index: 2016 Earnings / Revenue Growth

Source: Bloomberg, FactSet. Data as of November 2015. Earnings/Revenue Growth as of December 11, 2015.

For much of 2015, the top 10 stocks in the capitalization-weighted S&P 500 Index have accounted for a disproportionate share of its returns, something that's more common in periods of flat to modestly positive market performance. Looking at the issue from another angle, only 46% of stocks have outperformed the index, the lowest level since 2007. This has created a difficult environment. However, performance patterns of this nature have tended to be cyclical, and we believe that market dynamics are now shifting, with potential for higher dispersion and more breadth of contribution by stocks, with return differentiation driven by fundamentals.

Weighing the Risks

What are the key risks to our views on U.S. equity performance in 2016? As noted, one variable is China, where central bankers have a mixed record of success. If China's economic growth comes in lower than expected, that could further worsen global demand, pressuring emerging markets growth and, despite the domestic focus of the U.S. economy, ultimately harm expansion in the U.S. Another issue is the Fed. It has a complex task in tightening when much of the world continues to ease. If it moves very fast (as it did in 1994), the markets could face a severe recalibration and growth could fade more quickly than expected. Finally, we have to mention politics. The October budget deal effectively pushed out hard decisions until after the Presidential election, and current gridlock suggests that little of economic substance will be accomplished by Congress in 2016. Still, we anticipate a full range of hyperbole as November 3rd approaches, the nature of which could cause noise in the markets.

Ultimately, however, we believe that returns will be driven at the asset class level by macro issues and at the security level by the individual fundamentals of businesses and the markets they serve.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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