Most major equity markets started out strongly in 2015, peaked in the spring, and spent the rest of the year correcting. The S&P 500 managed to end the year just shy of its all-time high set in May. Most other indexes finished well off their peaks. Commodity-heavy stock markets—Toronto, London, and Sydney—fared relatively poorly as did those with strong China trade ties like Korea, Taiwan, and Singapore. Ironically China, its economy a source of so much of the weakness in markets elsewhere, saw its composite index notch up a world-beating 9.4% gain for the year despite a hair-raising summer rollercoaster ride that featured one four-week plunge of more than 40%.
Our principal focus is on the stock markets of developed countries. In most of these, economic expansions are well entrenched and, in the case of Europe, appear to be gathering momentum.
Underpinning this happy condition is a credit cycle that remains very accommodative. The Fed may have begun the process of gradually “normalizing” rates but European Central Bank policy has shifted in the direction of greater easing while any Bank of England rate hike is now viewed by the market as not likely before 2017. Meanwhile, central bankers in Canada and Japan have not ruled out further easing at this point, while India and China are almost certainly not finished cutting rates.
With monetary conditions this accommodative we expect the economic expansion and the accompanying growth of corporate profits both have a long way to run. In 2015, overall corporate earnings and investor confidence were shaken by the turmoil in the important energy sector. The continuing slowdown of China’s economy took an additional toll. As 2016 unfolds we expect conviction will grow that some stability is returning to the oil market and that Chinese economic performance is responding to lower interest rates, a weaker currency, and some fiscal stimulus.
Source - RBC Wealth Management; see “Views Explanation” on page 3 for details.
Investor conviction on these fronts and on the durability of the economic expansion in the U.S. and Europe should permit most major stock markets to follow earnings higher, delivering worthwhile all-in returns along the way. For a global portfolio we recommend a full commitment to equities up to its long-term targeted exposure.
- We expect U.S. equities to perform better this year following the -0.7% return of the S&P 500 last year. The U.S. economy remains on firm ground, in our opinion, and our base case assumes a healthy pace of job gains commensurate with a backdrop of moderate growth and benign inflation.
- We believe the equity market will successfully maneuver around the early stages of the Fed’s rate hike cycle. While a moderate pullback could be in order at some stage if history is a guide, we believe the secular bull market has further to run and will reward investors in 2016.
- U.S. equity markets have typically fared well on the heels of a year with flat returns, typically defined as returns of +/- 3%. The return of the S&P 500 was flat in 2015 using this definition. This bounce back can be attributed to a number of factors including growing investor confidence in the durability of the economic cycle and demonstrated resilience in corporate earnings. In each of the 10 years since World War II in which the S&P 500 recorded flat returns, the return in the subsequent year has averaged 13%.
- We favor secular and stable growers in the Technology, Consumer Discretionary, and Consumer Staples sectors. The Health Care sector appears to have strong long-term prospects, in our view; but, rhetoric emanating from the presidential campaign could lead to unwelcome volatility within the sector where multiples are unlikely to expand.
- Overall, we remain market weight with a negative bias for Canadian equities.
- The landscape for Canadian equities remains split between those with significant resource exposure—either directly or indirectly—and those without.
2015 Performance of Select Equity Indexes
Source - RBC Wealth Management, Bloomberg
Asia and Europe led, while Canada and emerging markets lagged.
- RBC Economics expects a modest uptick in Canadian economic activity in 2016 as exports expand in response to a weak loonie, consumer spending remains firm, and the drag from reduced business investment in the energy sector falls in magnitude.
- Within the Energy sector, we continue to focus on well-capitalized names that are positioned to weather depressed energy prices. We believe a “lower for longer” scenario that exerts further financial pressure on the sector may be the best tonic to effectively remove production capacity and deliver sustainably higher prices in the medium-to-long term. We stay cautious on base metal producers given a slowing China and its shift from investment-led growth to a more service-oriented economy.
- Bank equity valuations now reflect some of our concerns over slowing loan growth, margin pressure, and the risk of increasing credit losses. The magnitude of credit losses remains a key uncertainty, leaving us underweight bank shares relative to the index but ready to be opportunistic on further weakness.
- The Liberal Party’s pledge to boost infrastructure spending should create a tailwind for some infrastructure, construction, and engineering companies.
Continental Europe & U.K.
- We remain cautious on U.K. equities to begin 2016. We view consensus earnings growth expectations of 3% y/y as unattractive, especially in light of the upcoming referendum on EU membership that is likely to be disruptive in the short term. The rich valuation of U.K. equities does not reflect this risk, in our view.
- While our overall outlook is negative, we do see some opportunities in the U.K. equity market. Given the recent correction, some stocks are now in oversold territory. We would add to selective companies, particularly in the Health Care and Consumer Discretionary sectors.
- The consensus earnings growth forecast for 2016 is underwhelming, and could be further dented by both higher costs associated with the new National Living Wage and currency strength, as the corporate sector derives less than a quarter of its revenues from domestic sources.
- Moreover, the corporate sector’s generous dividend policies are now increasingly at risk. Cover ratios have deteriorated and now herald debt increases, dividend cuts, or both. The Materials and Energy sectors are most at risk, though Consumer Staples and Health Care may have to rein in expected dividend growth.
- Finally, U.K. equities’ 2016 price-to-earnings ratio of more than 15x appears unattractive given the uncertain and subdued outlook.
- We think prospects are brighter for equities in Europe. Quantitative easing is supportive, and a weak euro should underpin earnings expectations, which may be upgraded. Corporate profit margins have not peaked nor are valuations stretched, in our view. The migrant crisis has driven a sharp wedge through the region, and may ultimately threaten the EU’s core values of free movement of goods and labour. For now, we prefer domestic sectors, Telecoms, and Consumer Discretionary.
- Additional easing by the People’s Bank of China (PBoC) is expected in 2016, as policymakers try to counterbalance the effect of global monetary stimulus on the renminbi. Sluggishness in China’s heavy industry, manufacturing, and construction sectors is likely to persist into the early months of this year, although leading indicators have recently shown signs of stabilization. The services sector, still the largest sector of the economy, continues to register robust growth. Attractive opportunities for investors exist in areas such as clean energy, health care, insurance, and internet stocks.
- The Bank of Japan (BoJ) tweaked its ¥80T quantitative easing program in December, but offered no clues as to whether an expansion of its bond buying program may occur in 2016. Headline inflation continues to run below the BoJ’s 2% target with the changes announced last month unlikely to have a material impact on inflation or economic conditions.
- We view Japanese equities as attractive as they remain inexpensive relative to other developed markets. A number of Asia ex-Japan equity markets such as Hong Kong, Taiwan, South Korea, Indonesia, and Malaysia are also attractive due to compelling price-to-book valuations.