Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Simon Laing, head of US equities for Invesco Perpetual said that there was more to come from American markets.
We should be heading into 2015 with good momentum, similar to 2014. Hopefully we avoid the massive impact of weather that we had in Q1 2014 and we can see a steady trajectory of GDP improvement through the year at 2.5% to 3%. Employment is at a very healthy level. We like to look at initial jobless claims and those are right back down to 2006 levels.
The ending of quantitative easing (QE) in 2014 should be seen to have limited economic impact and won’t preclude a move in interest rates. We are in the camp that interest rates will probably start to rise sooner than most expect in 2015. But interest rates should also plateau out at a lower rate than most think because the level of GDP recovery is still not as robust as one would hope at this stage in the economic cycle.
With this economic backdrop, we see a decent year ahead for US equities. If you think of equity returns being made up of two components, earnings growth and valuation (the price you are willing to pay for those earnings) then both should help the US equity market higher. We think earnings growth for 2015 should come in around 4-5% on average. There will certainly be an earnings drag in the energy sector due to lower commodity prices but there should also be an offset from stronger consumer facing industries which benefit from lower oil and gasoline prices. When we think about the price earnings (P/E) ratio, we think that we could even see some expansion from the 16 times 2015 valuation.
Most quality US companies convert 100% of their net income to free cash flow so that 16 times P/E is equivalent to a 6.25% free cash flow yield. This looks attractive to us given the low level of bond yields and should be supported by a strong US dollar. We like the work of Cornerstone Macro on the subject of valuation and they show a strong negative correlation between P/E ratios and inflation. So, to the extent that we think inflation remains tame in 2015 that should again be supportive of higher equity valuations.
In summary, we see no reason not to expect another year of decent equity returns for the market.
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