We see 2016 as a year of positive but modest equity returns, with volatility continuing to play a visible role. There are 10 keys to success for this forecast:
- Slow and gradual tightening of interest rates by the Fed – Given modest growth in economic activity and a benign inflation outlook, we believe the Fed will raise interest rates judiciously. Investors who focus primarily on the negative aspects of higher interest expenses and headwinds to P/E multiples tend to overlook the benefits that higher interest income will have for the profitability of the financial services sector and for consumers and corporations with high levels of cash. Additionally, history has shown that rising interest rates are positively correlated with positive stock returns.
- Continued economic strength in the U.S., especially among consumers – The U.S. economy is expected to grow between 2.2% and 2.7% in 2016, which should produce solid job creation and further strengthen confidence among consumers and their ability to spend.
- Higher wage growth is likely around the corner – Due to solid job creation and the difficulty companies are having in attracting and retaining a high-quality labor force, wage growth is likely to increase from the current 2.3% level to approximately 3%. This increase, while lowering corporate profitability in the near term, is likely to bolster economic activity later in the year.
- Stabilization in China – While there has been increased concern due to volatility in the stock market and currency adjustments, we believe policymakers in Beijing are pursuing the right set of measures to shift economic growth from investment to consumption. While overall economic growth is likely to slow to around 6%, confidence in China is likely to stabilize, potentially eliminating an important source of risk for stocks.
- Improving global GDP growth – Overall growth in real economic activity around the world should increase from the low 3% range to the mid-3% range, providing opportunities for companies to increase revenues at a solid clip.
- Global earnings growth likely to improve – An expanding global economy and modest inflation should provide opportunities for companies to increase earnings. Cash flows should remain solid, fueling another year of stock buybacks. With interest rates rising, a stronger dollar is likely. This, combined with a modest decline in profit margins, is likely to keep EPS growth at approximately 6%.
- No major changes in an election year – U.S. voters are generally unhappy, but there is no consensus on what to do. Some think fewer taxes and less government is the correct path, while others favor more taxes and more government. Given this fact, we believe any sweeping mandates for change are unlikely, resulting in ongoing gridlock in Washington and a continuation of slow economic growth. This has historically been generally positive for financial markets.
- Reasonable valuations – Stocks are currently trading at 16x our forward multiple and could trade in the 16.5x to 17x range in 2016. Compared to bonds, stocks continue to be attractively valued. Our base case forecast is for stocks to reach 2063-2125 on the S&P 500.
- Recession unlikely – Our economic forecast calls for 2.2% to 2.7% real GDP growth with very little risk of recession, due to solid job creation, growing wage gains, and a slow and gradual rise in interest rates.
- Secular bull market intact – If we are correct in our first nine keys to success, the secular bull market should remain on track.
In summary, while risks from geopolitical tensions have increased in recent weeks, we believe stocks can withstand higher interest rates in 2016, since economic activity is solid, inflation is low, and the pace of the Fed raising interest rates is likely to be slow and gradual.
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