The foundation of economic growth and rising corporate profits will, in our view, extend the bull market. That said, we think this cycle’s largest gains are behind it, and in the latter stages of this expansion we expect more moderate returns, with an increasing probability of a temporary pullback this year.
A bumpier ride ahead
– As central banks – especially the U.S. Federal Reserve (Fed) – gradually withdraw stimulus, we believe stocks may be more prone to knee-jerk reactions to disappointing news, including weak economic readings (particularly in the U.S. or China), a drop in oil prices, a downturn in China or increased conflict with North Korea. Since 1980, in years when the Fed raised rates three times or more, U.S. stocks experienced an average of four 5% pullbacks and one 10% correction.1
Earnings in the driver’s seat
– S&P 500 revenue growth is forecast to double for the second straight year in 2018. We expect profit margins to compress as labour and investment expenses rise, meaning revenue gains will be increasingly important for ongoing corporate earnings growth – the most powerful driver of market performance over time.1
We believe domestic profits and performance will be particularly sensitive to commodity prices and bank results, warranting a modest valuation discount to the S&P 500. Broadly, we think earnings can rise at a mid- to upper-single digit rate, setting the pace for equity returns.
– The TSX and S&P 500 delivered average annual returns of 15% and 17%, respectively, in the past two years. Over the past 40 years, when twoyear gains exceeded 15%, the following two years saw average returns of 10.4% for the TSX and 15.8% for the S&P 500.1
Above-average valuations already price-in some future improvement, so we expect positive, but more modest stock market returns ahead.
Action for Investors - We recommend a neutral allocation to equities, and as appropriate, suggest buying on dips as they occur. We maintain our reduced allocation to Canadian equities and recommend sector rebalancing, noting our cautious view of domestic financials and our more positive outlook for energy, materials, industrials and technology.