August U.S. Equities Update


August 29, 2017

U.S. equities are not due for a major correction, meaning 10% or greater, given 1) U.S. economic indicators point to a low probability of recession 2) global growth, even including China at a 5-7% estimated GDP rate, is positive 2-3% and generally accelerating and 3) current U.S. earnings are accelerating at a double-digit rate year-over- year and comparisons are not difficult into year end.

While current U.S. price-to-earnings valuations are higher than long-term averages, they are not at peak valuations. The same holds true on a price-to-book metric and dividend payout ratios. With regards to sustainability, America’s largest companies are poised to post their second consecutive quarter of double-digit earnings growth for the first time since 2011. With nearly all S&P 500 companies reporting, second quarter earnings are tracking to rise in the low double digits year-over-year after a 15% increase in the first quarter. While earnings have been driven more by cost cutting and restructuring efforts, this quarter S&P 500 companies are experiencing revenue growth of ~5%, the second largest increase in more than five years.

S&P 500 Price-to-Earnings Ratios vs. Historical Levels

Current Levels Above Averages But Not at Peak Valuation

S&P 500 Index Forward Price-to-Earnings

S&P 500 Index Trailing Price-to-Earnings

Source: Bloomberg, TCW Portfolio Analytics

On a relative basis to major worldwide and the MSCI EAFE and EM indices, U.S. valuations are more expensive (please note in the table below, the highest valuations for each column are in bold), European and U.K. earnings per share growth estimates are not fully accounting for the potential of a hard Brexit, and Eurozone and Japan GDPs are estimated to be less than 2% over the next few years. Whereas, the U.S. has experienced a positive inflection in earnings growth starting in Q3:16 and 1-3% GDP over the last few years, and current estimates are for GDP to be in the 2-3% range. The Price Earnings to Growth Rate (PE/G) ratios (even given the potentially too high Eurozone earnings estimates) are still very attractive for the U.S. versus major developed market indices. While the MSCI EM Index ratios on all measures look to be quite attractive, the underlying returns are inherently more volatile.

Source: Bloomberg, FactSet,
TCW Portfolio characteristics and holdings are subject to change at any time.

Value vs. Growth

As it pertains to value versus growth in the U.S., we believe the pendulum may turn in favor of value. The uptick for value has room to grow as the ratio of price-to-book for growth-value is nearly at two-standard deviations below the mean. The last time this extreme was hit (November 1999), the trend soon reversed and led to value outperforming growth significantly.

Relative Price-to-Book – Value Versus Growth
The Uptick for Value in 2017 Has Room to Grow

Source: Russell, TCW
P/B is price-to-book ratio. Valuation is calculated by dividing P/B ratio of value stocks by P/B ratio of growth stocks.

Large Value vs. Large Growth

10-Year Rolling Excess Returns

January 1940 to July 2017

Source: FactSet, Bloomberg, TCW Portfolio Analytics Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group

Downside Risks

United States

The main downside risk to our outlook in the U.S. is policy and political strife in Washington. Much has to be accomplished before year end. Earlier this year, the U.S. government agreed on $1+ trillion bill to fund the government through the end of the fiscal year (September). Time is running short as Congress has yet to raise the government’s borrowing limit (despite estimates that the Treasury will run out of money at the end of September) and it still needs to draft and pass the new government budget. Meanwhile, national health care remains very contentious with the Better Care Reconciliation Act shot down and the most recent “skinny repeal” iteration of the Affordable Care Act failing. The White House would like one more vote on health care, while it appears Congress is aiming to “squeeze in” tax reform. The recent escalation in tension between the U.S. and North Korea along with the upcoming fiscal cliff already have been a drag on U.S. and worldwide markets with major indices down 1-3% over the two weeks ending Friday, August 18th (S&P 500 -2.1%, Euro Stoxx -1.7%, FTSE -2.1%, Hang Seng -2.2%, Nikkei -2.9%, MSCI EAFE, -1.7%, and MSCI EM -1.4%).

Remarkably, U.S. earnings growth has been accomplished despite sidelined policy initiatives such as corporate tax cuts and increased government spending on infrastructure. Several moderate pull backs of 3-5% would be “typical” in any calendar year and are not cause for investor alarm. One explanation for why these “typical” corrections have not occurred is the U.S. economy is exiting an asset reflation phase post the 2008 financial crises and is now transitioning into a more “normalized” economic environment. However, after years of global liquidity and still relatively accommodating global central banks, the tailwind remains positive. At the end of July, the preliminary U.S. GDP report for the second quarter came in at 2.6% quarter-over-quarter growth assuaging concerns stirred by the tepid first quarter figure. Current estimates for the third quarter are 3+%. Domestic growth in the second quarter was boosted by a rise in consumer spending, an improving trade balance aided by the weakening U.S. dollar, and new business investment (excluding residential) of 5%. Conservative estimates for the second half of the year are for 2.0–3.0% growth. The robust labor market has helped keep Americans upbeat about the U.S. economy. Americans continue to poll optimistic about the economy as reflected by the Conference Board Consumer Confidence and National Federation of Independent Business (NFIB) Indices. Additionally, U.S. consumers’ assessment of the labor market has become more positive with the index of those stating jobs are more plentiful at its highest level since before the financial crisis. The Bureau of Labor Statistics reported 220,000 (revised up to 231,000) nonfarm jobs added in June and another 209,000 in July. The unemployment rate now stands at 4.3%, the U-6 underemployment rate is 8.6%, and initial jobless (four-week moving average) claims are close to all-time lows. Average hourly earnings, as of July 31, are up 2.5% year-over-year.

While a more normalized economy will have expansions and decelerations, the likelihood of a U.S. recession over the next two years is below historical norms. However, the risk of policy errors with the new administration is greater, e.g., North Korea, the “One” China policy, etc. However, each “policy mistake” to date has been back tracked or modified by other government branches or administration members e.g., President Xi’s phone call with President Trump softening Trump’s North Korea and China rhetoric and the ouster of Steve Bannon.

The only one of ten leading economic indicators issuing a caution sign is the rising Fed Funds Rate. The Conference Board U.S. Leading Economic Indicator (LEI) of ten economic indicators hit highs in April, May, June, and July of this year. According to research from Evercore ISI, historically, when the LEI hits a cycle high, recessions follow four to eight years later. While four years is too far to look out, even within a Fed tightening cycle, the next 1-2 years holds a diminished chance of a recession and a major market correction. In our opinion, a conservative assumption of three to four additional hikes of 25 bps through 2018 and the prospect of the Fed’s balance sheet reduction (which is a de facto tightening) still leaves the targeted Fed Funds Rate below the “new” equilibrium of 2.5- 3.0%. We will be carefully monitoring each Federal Reserve move to ascertain any constriction of economic forces. For now, the U.S. yield curve is still positively sloped, especially for the 0-2 year portion, indicating bond investors believe GDP will continue to expand over the near term. The “flattening” of the curve farther out represents a question mark on the Trump administration’s efforts for fiscal stimulus. Energy prices at less than half the cycle peak represent real economic savings to consumers and industries.

Source: Bloomberg

According to the International Monetary Fund (IMF) following its Article IV annual review of U.S. economy, the U.S. is in its longest expansion since 1850. “The economy has gone through a temporary growth dip in the early part of this year but momentum has picked up and the economy is expected to grow at 2.1% this year and next, modestly above potential, supported by solid consumption growth and a rebound in investment.” Additionally, wage indicators have shown a modest acceleration and PCE inflation is expected in the next 12-18 months to “slowly rise above 2%, before returning to the Federal Reserve’s medium-term target of 2%.”


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