2018 Equity Outlook: Opportunities and Wild Cards in the Year Ahead
The signing of the tax reform bill by President Trump brought to fruition the changes to corporate taxes that investors have been anticipating in recent months. While the actual effects of the tax system overhaul will take time to work their way through the economy, much of the anticipated benefits have already been accounted for in current stock prices. As such, investors may be asking themselves, “What potential opportunities are left?”
To help us uncover these opportunities, we sat down with Bill Priest, CEO, Co-CIO, and Portfolio Manager for Epoch Investment Partners (“Epoch”), to get his views on the key drivers for the market in 2018.
Plunging Corporate Tax Rates…
Arguably, the most significant benefit coming from tax reform is the lower corporate tax rate, which fell from 35% to 21%. This is expected to boost the earnings for corporations that previously paid the highest rate.
Corporate Tax Rates
Source: Organization for Economic Co-operation and Development (OECD), 2017. Group of Seven (G7) Countries: Canada, France, Germany, Italy, Japan, United Kingdom, and United States.
…and a Host of Benefits
While higher corporate earnings are largely priced into current stock prices, investors may not have yet accounted for other key drivers of returns. With higher corporate earnings and less capital needed, due to the combination of the substitution of technology for labor and assets, Epoch believes investors will see more of the following in 2018:
- Stock buybacks
- Dividend increases
- Debt paydowns
These are all forms of capital returned to the owners of the business. And, with larger corporate cash levels expected as a result of lower taxes, Epoch believes that companies that focus on these activities should be rewarded by investors in 2018.
History has shown us that companies generating high levels of free cash flow outperformed those with lower levels. The chart below illustrates the cumulative relative performance of the stocks in the Russell 1000 Index, divided into quintiles, based on their trailing one-year free cash flow yield.
Companies with Higher FCF Yield Have Historically Outperformed
Source: Epoch Investment Partners. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Potential Wild Cards for 2018
In Epoch’s view, 2018 will bring new opportunities, as well as challenges that investors should be mindful of. The U.S. economy is in a late cycle, bringing with it questions around the probability of a recession. While volatility is expected to increase as the world’s major central banks move towards tighter monetary policies, Epoch believes there is only a low probability of a recession over the next 12 months. The Fed Funds Rate is still negative in real terms, profits are solidly growing, and more than 90% of global Purchasing Managers’ Indexes (“PMIs”) are showing economic expansion. While the overall economic picture continues to look promising, higher interest rates and lower liquidity present significant global macro risks, especially in light of many assets trading near historical highs.
As the market shifts from one that has been fueled by quantitative easing to one driven by fundamentals, companies with demonstrated ability to produce free cash flow and allocate cash intelligently should be favored by investors.
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Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Dividends fluctuate and are subject to change. There is no guarantee they will continue to be paid. While dividends may cushion returns in down markets, investments are still subject to loss of principal amount invested.
Actively managed strategies employ portfolio managers who decide, within the constraints of a prospectus, how assets are invested. For this service, actively managed strategies typically charge higher fees than unmanaged or passively managed strategies.
Free cash flow is the amount of cash a company is able to generate after making required investments in the existing business, such as for new machinery and to pay for supplies.
The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
New York Life Investment Management LLC engages the services of Epoch Investment Partners, Inc., an unaffiliated, federally registered investment advisor. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.