Although optimism is a late cycle phenomenon, history tells us the best returns often come at the end. It has taken eight long years to get here, but Wall and Main Street are finally starting to feel a bit better about the future.
The cyclical upturn that began a year ago has less to do with President Trump and more to do with the global business cycle that bottomed in 1Q2016. Trump simply “turbocharged” the cycle and stoked animal spirits on Wall and Main Street, with tangible effects on the real economy and markets.
The title of our year-ahead outlook as CIO for Morgan Stanley Wealth Management on January 1st (see excerpt at end) was “Are You Ready for Euphoria?”– based on Sir John Templeton’s four stages of the investment cycle: "Bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria." The end of the cycle is often the best. Think 1999 or 2006-07. In a low-return world, investors cannot afford to miss it.
Equity valuation remains undemanding in a low interest rate world. Equity risk premiums (ERPs) have been exceptionally elevated in the post-crisis era of lower growth and inflation, but we may be leaving that era, which means ERPs can and should normalize. Our 12-month base case S&P 500 target is 2700.
Secular Stagnation may be over, further supporting our expectation for falling equity risk premiums. Productivity may have bottomed, fueled by the end of trends that caused the slower growth in the first place: consumer over-indebtedness (housing), the oil bubble's tax on consumers, war on terror, demographics, and bad policy (regulation, lack of fiscal/monetary coordination).
Exceptionally loose financial conditions encourage the shift toward investor euphoria. Meanwhile, our proprietary institutional and retail data suggest US equity positioning is not extreme, and market technicals are in very good shape.
Our sector/style preferences reflect our pro-risk, late-cycle thesis. Financials, Industrials, Energy, and Technology are all overweight. We are underweight Real Estate, Telecom, and Staples. We are neutral Health Care, Materials, Consumer Discretionary, and Utilities. We have a preference for small/mid caps.
Risks: 1) We are late cycle and the Fed is further along than appreciated. This tightening cycle began in 2014 with the tapering of QE, which means there may be less headroom for actual rate hikes this cycle than assumed; 2) Commercial Real Estate and Autos are canaries in the coal mine that could spill over into broader credit markets; 3) Oil prices fall further and/or take longer than expected to recover—the Energy sector is the single largest incremental driver of S&P 500 earnings growth this year; 4) ECB tapering is not expected but it could happen this summer when political risks diminish in Europe.