Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Paul Quinsee, Chief Investment Officer, US Equities, J.P. Morgan Asset Management considers which equity sectors offer the best returns.
Returns from US equities are moderating and stock market volatility is on the rise. We can hardly complain; their performance over the past few years has been nothing short of spectacular, and since 2011 volatility has been very subdued as well. Of the three drivers behind these excellent returns; low valuations, strong profits and low interest rates, the first is now clearly in the past, with the S&P 500 trading at around 17x our forecast of normalised profits.
The market will be harder to live with from here
But companies are still performing well for the most part, with upside ahead as the domestic economy continues to grow and financial sector conditions normalise.
This year’s earnings growth will be slower; we expect only 2% growth in revenues as the lower oil price and higher US dollar weigh on results.
The macro-economic backdrop for the stock market is rather mixed. Most companies report improving business conditions in the US, although economists have been revising down their GDP forecasts again. There are also increasing concerns about weakness in Brazil, Russia, China and many other emerging countries, while sharply lower commodity prices are a challenge for the energy and basic industries groups.
Our own earnings expectations have declined; we now expect aggregate earnings per share this year to be down around 5% from our forecasts in early January. However, the weakness is very concentrated in the energy/commodity sectors, where profits will drop by at least 50% this year, and the big overseas earners, with the trade-weighted Dollar index rising at breakneck pace recently and now over 20% higher than a year ago. But for most companies, business remains good, cash flows are strong and the picture looks much better than a glance at overall profit numbers would suggest.
We are still only in the middle stages of the business cycle, and the underlying business fundamentals in most industries continue to look very good – market gains may well continue to power on from here.
Meanwhile dividends are rising faster than profits and share repurchases are at a record high. With cash flows and balance sheets strong, investment spending subdued and a growing horde of activist investors putting more management teams under pressure, we expect the return of capital to shareholders to remain a key feature of this business cycle.
M&A is on the rise, which of course makes investors with long memories nervous, but so far most deals seem sensible and with no return on cash available, typically accretive to earnings as well. So we see the strength of the corporate sector as a continued support to stock prices, even as headline earnings will be around flat this year.
Interest rates are of course still incredibly low; we could see an increase of more than 1% in long term bond yields before the valuation of equities is called into question. So equities remain a reasonable investment, even if the market will be harder to live with from here.
The financial sector is a place where we still find plenty of attractive stocks, particularly from a core and value equities investor standpoint. Higher interest rates and lower legal costs should add to existing trends towards strong credit quality and better loan growth, and there is room for at least a cyclical improvement in investment banking profits as well. We also find many attractive names in the consumer cyclical industries.
Conversely, the high prices and limited growth opportunities of many utility, telecom, real estate and consumer staple stocks hold little appeal. From a growth investing perspective, we see plenty of opportunity in their longstanding favourite sectors of biotechnology and social media, and have also been adding to semiconductor investments and good quality companies that stand to benefit from a potentially long lived recovery in the housing market.
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