As discussed in our just released Midyear Outlook 2016: A Vote of Confidence publication, we continue to expect mid-single-digit returns for the S&P 500 in 2016, consistent with historical mid-to-late economic cycle performance. We expect those gains to be derived from mid- to high-single-digit earnings growth over the second half of 2016, supported by steady U.S. economic growth and stability in oil prices and the U.S. dollar. A slight increase in price-to-earnings ratios (PE) is possible (up from 16.6 times consensus forward earnings estimates) as market participants gain greater clarity on the U.S. election and the U.K.’s relationship with Europe, and begin to price in earnings growth in 2017. Low interest rates continue to provide support for stock valuations, making bonds a relatively unattractive alternative to stocks.
Key risks include a policy mistake from Washington or the Federal Reserve (Fed), geopolitics including political uncertainty in Europe, and a surprising pickup in inflation that leaves the Fed playing catch-up. We expect to experience more bouts of volatility given these risks and being in the later stage of the business cycle.
Following several quarters of earnings declines, a turnaround in growth should support our forecast for mid-single-digit gains for stocks in 2016. Despite the slow growth of the U.S. economy, we continue to believe the conditions are in place for a solid rebound in corporate profits during the second half, due to the easing drags from the U.S. dollar and oil, coupled with minimal wage pressures. The recent improvement in the Institute for Supply Management’s (ISM) Purchasing Managers’ Index (PMI) for manufacturing, which has shown high correlation to corporate profits historically, is encouraging.
How to Invest
We believe these ideas have earned the votes for including in suitable investors’ portfolios for the second half of the year:
- Large caps: As the economic expansion transitions from mid-cycle to the latter stages, we favor the generally less volatile and higher-quality large cap stocks.
- Growth stocks: We expect continued, though modest, economic growth to favor growth over value as markets reward those companies that can produce above-market earnings growth.
- Cyclical stocks: We expect cyclical stocks to benefit from the ongoing U.S. economic expansion and improving economic growth in the U.S. and emerging market economies.
- Master limited partnerships (MLP): As the business cycle enters its latter stages, we could see a surprise late-year pickup in inflation, supporting the energy sector and high-yielding MLPs, which should also benefit from balancing of supply and demand in the oil market in the second half.
- Healthcare: The latter stages of the business cycle also offer a historically attractive opportunity for healthcare investments, which are attractively valued due to the market’s overly pessimistic view of political risks, in our view.
- Emerging markets (EM): We see EM as an attractive opportunity due to low valuations and a likely boost from fiscal and monetary stimulus.
We see emerging market equities as an increasingly attractive opportunity. We have become more constructive on energy and MLPs. And we have become more cautious on developed international equities due to stalled economic growth, the much needed structural reforms that are still remaining, and political uncertainty surrounding Brexit.