Market Outlook: New Expectations Set the Tone for 2017
Following the Trump victory, the market has incorporated expectations for stimulus, higher inflation, and higher interest rates.
During the final quarter of 2016, U.S. financial services stocks reacted the most favorably to news that Donald Trump would become president. The Morningstar Financial Services Sector Index has risen 20% quarter to date. While financial services was one of our most undervalued sectors at the time of our last quarterly update, the price/fair value estimate ratio for the sector is now 0.97. The market has incorporated expectations for stimulus, higher inflation (from stimulating an economy already close to full employment), and higher interest rates (from higher budget deficits and inflation).
At the other end of the spectrum, the Morningstar Real Estate Sector Index fell 4.55%. Those same interest rate expectations that lifted financials stock prices have hurt real estate valuations, as investors incorporate higher costs of capital for REITs and turn to other increasingly attractive vehicles in their search for yield. The price/fair value estimate ratio for our real estate coverage is 0.93.
In addition, the Morningstar Healthcare Sector Index has fallen 4% quarter to date. There is increasing concern surrounding the pricing power for drugs. Powerful pharmacy benefit managers will likely continue their drug pricing pressure. However, we argue that the research and development landscape is quite good as successful drugs are coming to market more rapidly than before, which should offset drug pricing pressure.
Basic materials continues to stand out as the most overvalued sector. We think the market incorrectly assumes current commodity prices are sustainable, as we are bearish on the long-term outlook for Chinese fixed-asset investment despite Beijing’s stimulus efforts. We fear that China’s ability to sustain rising fixed-asset investments will falter due to high debt and falling returns on investment. Moreover, new supply can enter the market, which should provide further pressure for commodity prices long term.
We also view the energy sector as overvalued, with a price/fair value estimate ratio of 1.14. Our long-term oil price assumption of $55 per barrel for West Texas Intermediate remains, despite OPEC production cuts. We argue that even a modest recovery in oil prices will encourage U.S. shale producers to further ramp activity so that they eventually replace almost all "removed" OPEC barrels with their own.
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