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Market View

Lord Abbett experts address investors’ equity-market concerns and highlight the opportunities for 2016.

Market Summary
Volatility was the chief characteristic of global equity markets in 2015, with central bank monetary policies, China’s managed transition to a consumer-based economy, sharply falling oil and other commodity prices, and rising geopolitical concerns at the root of it all. Economic growth also disappointed, particularly in China, but also in the eurozone, where still-tepid growth motivated the European Central Bank to continue its quantitative easing strategies. The U.S. Federal Reserve (Fed), on the other hand, stood poised to raise its fed funds rate on indications of an improving U.S. economic picture—a move that would also restore a key tool of monetary policy, i.e., the ability to lower rates in the event of another economic slowdown.

Despite data showing a strengthening economic recovery in the United States, some U.S. companies, particularly in the energy, materials, and industrial sectors, saw a decline in profit margins in the final half of the year, with consecutive quarters of decline effectively signaling a profit recession. A profit recession, however, is not a reliable indicator of an economic recession, which, with U.S. gross domestic product (GDP) hovering around 2.5% at 2015 year-end, we do not expect to see in 2016. U.S. growth rates may not be stellar, but at least they are maintaining a slow and steady pace in the right direction.

For insights into what all of this means for investors in 2016, we asked some of our investment professionals to weigh in on their outlooks for the global equity markets in 2016. Brian Foerster, U.S. Equity Strategist, looks at the U.S. economic scenario and identifies industries that have the potential to rise above a slow-growth environment. Joseph M. Graham, Investment Strategist, examines the profit recession and valuation disparities and makes the case for dividend stocks. And Harold E. Sharon, Partner, International Strategist, discusses prospects for fiscal stimulus in China that would boost economic growth there, points to signs of economic momentum in the eurozone, and gives a stern appraisal of Japan’s three-point economic plan.

U.S. Equity: Pockets of Growth
by Brian Foerster, Equity Strategist

Ever since the Great Recession of 2008–09, which precipitated the biggest federal bailout of Wall Street in history, market skeptics have been forecasting a second, far worse collapse in the equity markets that will, some argue, finally compel the U.S. financial system to pay for its excesses in prior decades. Nonetheless, despite some dips in 2011, 2012, early 2014, and this past summer, when markets flirted with short-lived corrections and near-bear markets, the dreaded collapse has not come—not yet, at least.

The initial premise of the skeptics was that we were setting the stage for an epic collapse in two ways: 1) because there has been a massive transfer of bad real estate debt from the private sector to the public sector, and most notably to the Federal Reserve’s balance sheet, and 2) because of deficit spending, which quickly pushed the national debt from 65% of gross domestic product (GDP) in 2007 to more than 100% of GDP today. We still don’t know how the great central bank experiment of massive quantitative easing and zero-bound short-term interest rates fully plays out, but for the moment, the Fed’s monetary exit strategy appears plausible, as the central bank gradually sells off its bond holdings.

Today, those fond of making “black swan” forecasts are keeping a watchful eye on higher equity-market valuations and on the substantial amount of financial engineering that has taken place, and continues to take place, via corporate buybacks, which are increasingly viewed as a form of leveraged earnings manipulation fueled by low borrowing costs and the quest to generate earnings growth in the absence of revenue growth.

While S&P 500® Index aggregate earnings are weighed down by the energy and materials sectors and GDP growth continues to underwhelm, well-positioned companies in this environment have the potential to thrive. We believe three themes likely will gain traction in 2016:

1) Forgive us for being repetitive, but the muddle-through economic backdrop will continue.
The expected Fed “liftoff” on December 16—which is when the Federal Open Market Committee next meets—is likely to be the start of a very shallow path for interest rate increases. While the Fed is determined to raise the fed funds rate from zero and, by so doing, put some recession-fighting tools back into its kit, the central bank is still by all accounts dovish, due primarily to its fear of triggering the very recession it wants to eventually fight. We believe the continued low rate of inflation—whether it’s the core Consumer Price Index at 1.9% or the core Personal Consumption Expenditure Price Index at 1.6%—combined with GDP struggling to stay north of 2% per year makes it unlikely that we will see any aggressive rate-hike program in 2016.

With the global economy slowing due to decelerating growth in China and anemic growth from the eurozone, not to mention the worst recession in decades in Russia and Brazil, there are risks as well of importing deflation, should growth slow more than expected in those regions. Offsetting these negatives, though, are signs of wage growth in the United States, thanks to a much improved employment picture and pockets of organic growth in the U.S. economy that have been driving the recovery in recent years.

In sum, our base case is that these opposing forces will keep a lid on inflation and interest rates here in the United States, which in turn suggests that we will not face a recession, and that the slow pace of economic growth, to which we’ve become so accustomed, will continue.

2) Lower commodity prices eventually become a good thing.
Remember 2005, when the biggest risk in the economy was spiking oil prices? Sticker shock at the pump was going to cripple growth as consumers would have less disposable income to spend. (That phenomenon was, of course, softened by the ability of homeowners at that time to simply use their homes as ATMs with no expected consequences.) Today, we’re at the opposite end of the spectrum. Oil prices have been declining sharply, pulling S&P 500 aggregate earnings lower, as the energy sector, in particular, feels the pinch of declining profit margins. But this pain should subside in 2016 once the long-awaited flow-through of lower input prices (not just for oil but also for other commodities, such as copper) benefits various sectors of the economy, including consumer spending.

3) Industries in secular bull markets will transcend the low-growth economy.
Despite the slow-growth economy, the S&P 500 is still trading today at 19–20 times trailing earnings and almost 17 times some fairly lofty 2016 earnings predictions from both Standard & Poor’s and FactSet. In a market where aggregate corporate earnings are stagnating, growth has, indeed, become scarce, and investors have been paying up for it when they find it.

Clearly, there are segments of the economy that are thriving. Some industries, for example, are experiencing secular bull markets, and they have been for a long time. These include Internet retail, health care, and telecom, where earnings and revenue growth are solid, despite the weakness of the global marketplace. Another potential bright spot are smaller and mid-sized companies, which are less sensitive to slowing global demand and a strengthening dollar, and thus likely to outpace companies that are dependent on expansion into China and other emerging markets.

This bifurcation in the U.S. equity markets—a “winner-takes-most” environment, at least for the time being, where strongly positioned leaders take market share and the rest muddle through—means one thing in our opinion: Active management should be crucial if equity investors are going to avoid companies that are poorly positioned and, instead, find winners that can deliver potential returns.

U.S. Equity: Earnings Trends and Valuations
By Joseph M. Graham, CFA, Investment Strategist

First, a disclaimer: we believe any short- to medium-term prediction of overall stock market returns should not be a focus for our clients or for us. It is common to read market-level predictions in these year-ahead outlooks. The truth is that stock market returns essentially are unknowable in the short to medium term.

For example, price-to-earnings (P/E) ratios don’t predict forward-year returns at all. This isn’t to say that initial valuations mean little for investing—they do. Valuation can be an important driver of longer-term returns. On that front, we are at a little more than 16 times next year’s operating estimates, which is a fair level considering where bond yields are. But in the short to medium term, this level means little in terms of predictive power.

Earnings play a similar role. Corporate earnings are a key driver of economic growth, and an even more essential driver of long-term market returns. And over the last three quarters, earnings have contracted year over year. Nonetheless, we also know that earnings recessions do not necessarily predict economic recessions and that they are even less predictive of market direction over the short to medium term. Consider, for example, that an investor would have averaged, since 1960, an 11% return investing only during the 16 calendar years in which earnings declined. Four of those 16 years did not coincide with an economic recession. Investing in only those four years would have resulted in a 22% average return. So, as the historical record shows, rather than being a predictable detractor from performance, investing in times of declining earnings offers the potential to be rewarded with outsized gains.

Looking ahead to 2016, we can be reasonably sure of a few things:

1) Earnings trends will be a hot topic for debate.
Regardless of their impact on market direction, we do know that earnings trends will be much scrutinized because of their multiyear strength and recent weakness. Analysts typically are optimistic looking forward one year, and this year is no exception. According to FactSet, bottom-up S&P 500 operating earnings for 2016 are forecasted to rise about 8%, to $128 per share, from the $119 estimated for 2015.

There is cause for doubting that earnings expectations will stay this high. They generally come down as the year approaches, and then more realistic (or more beatable, depending on your level of cynicism) estimates are supplied. So, if that FactSet estimate of $128 per share for 2016 eased to $125 over the next few months, the market likely would not react in a significant way. A number such as $115 or lower, implying continued contraction relative to 2015, however, would be a disappointment, and could result in lower equity prices. Also remember that there is a slight tailwind here from inflation, and a more substantial tailwind from the rash of share buybacks that may increase earnings per share numbers in 2016, all else held constant.

The 2015 earnings environment was characterized by revenue contraction, with some margin expansion helping to offset that. But this overall result obscures a lot of moving parts, as falling prices for commodities substantially reduced revenue and profit margins in the energy and materials sectors, while more stable prices in other industries allowed the reductions in commodity input costs to translate into improved margins. Some argue that margins are quite high relative to history, and that tailwinds of falling commodity prices and a benign labor environment are unlikely to persist. If earnings are to rebound in a significant way in 2016, the argument follows, it most likely will come from top-line growth. We don’t disagree, but we see no reason to be overly negative on margins. Much of the difference in current margins from historical norms is the result of a combination of lower taxes, lower interest expenses, and structural changes in the technology space, none of which will change dramatically in the next few years.

2) Dividends will continue to increase in importance.
Dividends will play an outsized role in investor returns going forward. Historically, over 40% of an investor’s return in the U.S. market has come from dividends. That has abated in recent decades due to tax policies and a general focus on capital gains. But the global wave of aging and retiring populations comes with income needs that are not being met by bond yields. Compare the Barclay Capital U.S. Aggregate Bond Index yielding around 2.5% with earnings yields on the S&P 500 at more than 6% on a forward-earnings basis.

Healthy dividend-paying stocks that can deliver this earnings yield in a relatively predictable manner command a premium. Company managements see this premium, and increasingly choose shareholder-friendly dividend payouts. If they don’t, influential investors, including activists or other companies with acquisitive mindsets, will ensure that they at least consider it. Further, payout ratios, while they’ve been increasing in the last few years, are still well below historical averages. We think this provides room for dividends to drive an increasing portion of returns going forward.

3) Valuation disparities will provide active managers with meaningful outperformance opportunities.
Valuation dispersion (as measured by the average difference in forward P/E) is at a post-financial crisis high. This dispersion exists because momentum has been such a powerful driver of relative returns in the last year. When past momentum drives returns, the dear become more dear and the shunned more shunned, creating opportunities for active management. Active managers with valuation sensitive approaches are in an especially favorable position to capitalize on the disparity by constructing portfolios of undervalued stocks that have been unduly punished by trending markets.

 

Chart 1. Valuation Dispersion Is at Post-Crisis Highs
Dispersion of forward P/E ratios for S&P 500 Stocks,* 1990–October 2015

Source: FactSet and BofA Merrill Lynch U.S Equity and U.S. Quant Strategy.
*Excludes companies with negative EPS and outliers with a Z-score >2. (A Z-score is a statistical measurement of a score’s relationship to the mean in a group of scores. A Z-score of 0 means the score is the same as the mean.) Dispersion is standard deviation/absolute value (average).

 

International Equity: China, the Eurozone, and Japan
By Harold E. Sharon, Partner, International Strategist

As China continues to shift away from debt-financed fixed-asset investment and toward a more sustainable, domestic consumption-led economy, its efforts are creating a widening circle of victims. From metals and energy sectors, to commodity economies such as Australia, to neighboring Asian trading partners, to Germany’s exports, China’s weakness is reverberating around the globe.

As we look ahead to 2016, what follow are areas that not only warrant careful scrutiny but also may offer investment opportunity.

1) China may resort again to more stimulus to boost its economy.
China’s plan to shift to a consumption-driven economy has been in operation now for several years, and we can readily see the initial impact on markets and the economy. But the secondary effects have yet to be seen. This is the point in the cycle when over-leveraged countries or companies may run into difficulties—especially if rates increase in the United States. While our eyes remain open to a few investment possibilities, clearly we are attuned to the trouble spots of excessive leverage.

But we’re also anticipating that China’s transition will be a longer and tougher one than they expect. And that might have some positive implications. A likely scenario is that as consumption disappoints in China, the nation’s policymakers will resort to classic fiscal stimulus via infrastructure investment, much as they did during the economic downturn in 2009. We’re already seeing monetary stimulus via lower rates in China, so there is the possibility that fiscal stimulus is next. If so, we will look for the beneficiaries, which could provide a bright spot in the Asian markets and possibly provide a reprieve for other commodity countries or emerging markets.

2) Anti-austerity in Europe could add some momentum to the eurozone economy.
Slowly but surely Europe is coming back to life. Unemployment is now at a four-year low, but still too high. Credit is finally expanding, with both individuals and corporations borrowing for the first time in years. Credit growth is a good sign of future optimism in eurozone growth prospects. All of this has created a bit of breathing room within eurozone government budgets for next year. Every government is now substantially below the eurozone’s fiscal “Early Warning Indicator” (see Chart 2), meaning that there’s room for either tax cuts or spending initiatives to spur growth.

The implications are that for the first time since the crisis started unfolding in the eurozone, there may be policy support for growth from both the fiscal and monetary sides. This, together with continued optimism and credit expansion, could provide the necessary impetus to see broader and more assured growth throughout the eurozone. If so, we would expect companies exhibiting solid growth prospects to do well. In addition, small-cap stocks have tended to do well during economic recoveries.

 

Chart 2. Early Warning Signs Are Easing

Source: Deutsche Bank.

 

3) Next year will determine whether or not “Abenomics” is a spent force.
Much has been made of Japanese prime minister Shinzo Abe’s three-point plan (so-called “Abenomics”) to revive growth in the country. But the slow pace of true economic reform—particularly in the labor market and in opening up competition—has blunted the force of his efforts. Was Abenomics really a radical economic plan, or has it been merely the last gasp of breath from a tired nation seemingly entrenched in its old ways? The year 2016 will be a crucial test for Japan as the country has taken on substantial debt in order to try to combat a persistent deflation. While inflation has ticked up modestly, it hasn’t yet been able to move wages or increase consumption—the largest part of Japan’s economy.

Clearly, the overall decline in commodity prices has not helped any inflation-targeting central bank around the world. But as price indexes are re-set in 2016, reflecting the commodity price declines of 2015, central banks could have an easier time reaching their inflation targets. The implication would be that it could buy more time for Abenomics to truly get to work with the supply-side reforms that were promised, but that have been slow to gain traction. If the economy continues to deflate, however, Abe will be left with few choices to revive Japan and will be left hoping that the United States and the eurozone come to his rescue.

 

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