December 2016
Equity Sector Outlook 2017 Outlook Prepared By: Michael Behan, CFA Equity Sector Analyst, Team Leader Financials Joseph Buffa Equity Sector Analyst Utilities Telecommunications Services Thomas Christopher Equity Sector Analyst Information Technology Michael Colón Equity Sector Analyst Health Care Materials
2017 Equity Sector Expectations The Wells Fargo Investment Institute (WFII) has a constructive outlook for large-cap equities and we see numerous themes that could play a significant role in sector performance for 2017. As we move farther along in the economic cycle, we are mindful that market volatility has been muted for the last several years, which may potentially lead to investor complacency. We believe there are incrementally better opportunities in value opposed to growth stocks. The pace of growth and macroeconomic conditions could shape our views on various industries as we move through 2017. Wage growth trends appear to be firming as the labor market tightens. As a result, employers will probably need to raise compensation to attract and retain employees. This could have a negative marginal impact on labor-intensive industries such as hotels, restaurants and retailers. These factors have caused us to favor tobacco and internet retail in the Consumer sectors. Interest rates and oil prices are other major areas of focus in relation to industry themes and overall equity market performance. The price of oil is a large contributor to Energy industries with Exploration and Production (E&P) being the most exposed. Given current valuations, our advice is to remain in the integrated oil industry. The trajectory of interest rates affects banks, brokers and life insurance industries most and we prefer investing in life insurance companies for investors looking to hedge higher interest rates. Recent high profile cases of excessive drug pricing leave business models within pharmaceuticals, distributors and prescription benefit plans under the microscope of Congress and could weigh on returns in the near-term. These factors have led us to prefer the medical device industry. We believe technology industries will likely benefit from the cloud and favor software and semiconductors industries.
Daniel Moisio, CFA Equity Sector Analyst Energy Brian Postol Equity Sector Analyst Consumer Discretionary Consumer Staples
The low interest rate environment has created more demand for yield, and we expect companies to respond to this by focusing on dividend growth. Within income oriented industries, we prefer select net lease and specialty and industrial REITs, diversified telecom services and gas and electric utilities with a bias toward names that can exhibit higher relative industry growth, often resulting in lower relative dividend yields.
John Sheehan, CFA Equity Sector Analyst Real Estate Industrials
2017 Equity Sector Weighting Guidance Global Industry Classification Standard (GICS) Industry Guidance Overweight
Evenweight
Underweight
1
Sector
More Favorable
Less Favorable
Consumer Discretionary
Internet Retail, Specialty Retail
Multi-line Retail 1
Health Care
Medical Devices, Pharmaceuticals
Health Care Facilities, Laboratories
Industrials
Industrial Conglomerates
Transportation
Information Technology
Software, Semiconductors
Hardware
Financials
Life and Non-Life Insurance
Banks, Asset Managers
Telecommunications
Integrated Telecom
Wireline
Materials
Specialty chemicals, Industrial Gases, Agriculture
Basic Metal & Mining
Real Estate
Net Lease, Specialty REITs
Lodging, Apartments, Self-Storage
Consumer Staples
Tobacco
Food Products
Energy
Oilfield Services, Integrated Oil, Mid-Stream MLPs, Energy and Production
Upstream MLPs, Offshore Drillers, Oil tanker & marine MLPs
Utilities
Gas, Electric, Multi-line
Unregulated
We favor off-price retailers within multi-line retail Source: Wells Fargo Investment Institute, Wells Fargo Advisors Advisory Services Group, as of November 29, 2016.
1
2017 EQUITY SECTOR OUTLOOK
CONSUMER DISCRETIONARY 2016 Sector Performance Despite strong price performance from the Leisure Products and Internet Retail sub-industries, the S&P Consumer Discretionary sector has underperformed the broader market year-to-date. Anything related to apparel – Textiles, Multiline Retail and Specialty Retail – have all posted weak year-to-date returns. In addition, auto components and automobiles have also posted negative returns as investor concerns with future automobile sales trends moderate.
SECTOR DRIVERS AND THEMES FOR 2017 We view the growth of e-commerce as the most disruptive occurrence related to consumer lifestyle and consumption habits today. Internet-based retailing has given consumers the ability to identify and purchase goods based on obtaining the lowest price. Further, additional incentives such as free shipping or corporate reward incentives leave retail companies with strong customer brand allegiances. Companies that control the distribution and pricing of their products look increasingly attractive. Without question, we are seeing a notable shift of capital expenditures directed toward e-commerce platform build-outs and enhancements across several companies. Our view is that these types of companies offer the potential for the best sales growth, as well as the fastest earnings growth potential, provided they are well managed.
E-Commerce Sales in Relation to Total Retail Sales 45
8.0
Year-over-Year % Change in Sales
6.0 5.0
25
4.0 3.0
15
2.0 1.0
5
0.0 -1.0
-5
E-Commerce Sales as a % of total Retail Sales
7.0
35
Annual e-commerce growth rate has exceeded the growth rate of traditional brick-andmortar in each of the last 15 years and today accounts for roughly 8% of total retail sales. Shop.org forecasts suggest that e-commerce sales will account for 10% of total retail sales within the next three years.
–
Total Retail % change YoY
–
E-commerce % change YoY
–
1Q16
1Q15
1Q14
1Q13
1Q12
1Q11
1Q10
1Q09
1Q08
1Q07
1Q06
1Q05
1Q04
1Q03
1Q02
-15
1Q01
-2.0 -3.0
E-commerce % of Total Retail
Source: U.S. Census Bureau as of June 30, 2016
WHERE TO INVEST IN 2017 Digitization is fundamentally changing the way consumers live through retail trade, leisure, education and mobility. The speed and complexity of this process of change is enormous. The growth of e-commerce has progressed unabated in recent years and we continue to believe investors will remain enamored with the Internet Retail sub-industry. More importantly, it is widely understood today more than at any time in the past that the growth of online commerce is tied to structural change and physical sale floors are under pressure. The rate of frequency of consumer purchases are migrating to the internet, sales floor productivity is decreasing, and a growing number of millennials believe that online stores could replace physical stores in the future. However, it’s also evident that the sales floor has not become obsolete. Traditional retail will not go away, but it is likely to evolve. Therefore, we are increasingly more focused on business models that are capturing a greater percentage of consumer wallets through mobile devices. These are companies who are engaging shoppers according to their context and specific needs, offer same-day delivery, and provide free-delivery and returns. The POTENTIAL TAILWINDS & HEADWINDS one sub-industry that appears to be lagging capital deployment to Falling gas prices and an improving job market should provide e-commerce distribution and logistics build-outs is the Multi-Line consumers with increased disposable income. On the flip side, higher Retail, particularly traditional department stores. wages are a catch-22 for the Consumer Discretionary sector. On the Lastly, after years of delays, consumers have focused on large-ticket, one hand, higher wages are positive overall for the U.S. economy and durable purchases (automobiles, homes, appliances, etc.) recently. for consumer spending. However, sectors and industries with a high Many of these purchases are facilitated with some form of financing labor component (ie: Restaurants, Hotels/Resorts/Cruises, Retail, and (ranging from 6-months to 30-years), which shrinks the available Advertising) will probably receive less incremental benefit given the amount of monthly disposable income for consumers. This suggests increased operating expense impact on profits due to higher wages. “value” remains at the forefront for consumers and, therefore, we continue to favor the “off-price” retailers. 2
2017 EQUITY SECTOR OUTLOOK
CONSUMER STAPLES SECTOR DRIVERS AND THEMES FOR 2017 There are at least three important factors expected to drive performance in the Consumer Staples sector in 2017: stable growth, attractive returns, and solid countercyclical share-price performance. The sector has offered strong earnings growth opportunities across economic cycles and the high-return nature of these businesses has delivered excess free cash flow after funding operations. Consumers are staples purchasers regardless of the state of the economy, making Consumer Staples minimally cyclical. Therefore, the stocks generally afford countercyclical relative price performance, providing the rationale to own the sector for both absolute return and diversification. Broadly speaking, the benefits felt from lower gas prices, higher minimum wage rates, and improving employment all bode well for sustainable and growing consumer spending trends.
2016 Performance The Consumer Staples sector in the first-half of 2016 materially outperformed the S&P 500. The sector had lackluster performance during the second-half, erasing all earlier gains and retreating even further. The best performing sub-industry has been tobacco. We believe this performance was helped by low gas prices, improving minimum wage rates and rising employment levels. Food & Staples and Personal Products were the worst performing sub-industries within the overall Consumer Staples sector in calendar 2016.
U.S. Food Sales Growth 25.0%
20.0%
Consumer preferences for healthier eating and living has led to sustainable market share gains within the natural/organic food category. Expectations are for these trends to persist over the coming years led by the Millennial generation.
Year-over-Year
15.0%
10.0%
5.0%
0.0% 2000 -5.0%
2001
2002
2003
2004
2005
2006
2007
– – Total
2008
2009
2010
2011
2012
2013
2014
2015
Natural/Organic
Source: U.S. Department of Agriculture, U.S. Census Bureau ; data as of December 2015
Where to Invest IN 2017 In general, we remain selective in our recommendations across the POTENTIAL TAILWINDS & HEADWINDS Consumer Staples sector. Given above-average valuations and the potential for hike(s) in interest rates, our focus is on sub-industries A continued moderate domestic economic recovery, rising with identifiable growth initiatives to drive investor interest. Tobacco wages, further stabilization of commodity costs and improving comes to mind given the innovation of reduced-risk products (RRP) employment are all helpful contributors towards future consumer coming to market. Despite global cigarette volume weakness, strong spending patterns and profitability algorithms for the majority of product pricing and industry RRP introductions in 2017 should create the Consumer Staples companies. The largest headwinds facing the strong future growth potential within the industry. Furthermore, Consumer Staples sector in 2017 are further weakening in emerging tobacco consumption trends historically index well against low gas market economies, sustained appreciation of the U.S. dollar and prices, rising minimum wages, and improving employment. rising interest rate expectations. We find companies that benefit from health and wellness trends to be attractive. Consumers around the world are pursuing and living healthier lives. This lifestyle choice is directing behaviors such as purchasing habits and leisure activities. These patterns support companies including organic grocery stores, household and personal care products, and organic/natural food and beverage manufacturers. Companies with the strongest health and wellness positioning have had the highest growth rates in recent years. Price points are also higher for these same top-quartile companies, seemingly revealing consumers’ willingness to pay a premium for such attributes. These on-trend product portfolios seem to have abundant room for growth as they command a small fraction of their total addressable markets. We remain cautious on the food industry given sluggish sales growth and high relative multiples. Earnings visibility remains strong given heavy focus on costs savings, however, top-line growth remains anemic across the board. The one factor that could push food valuations higher is the heightened talk of large-scale consolidation in the category. 3
2017 EQUITY SECTOR OUTLOOK
ENERGY 2016 Performance The Energy sector has easily outperformed the broader S&P market year-to-date. These gains have been led by the exploration and production and equipment and services sub-groups. Our favored sub-industries of integrated oil companies (IOCs) and large-cap mid-stream master limited partnerships (MLPs) had positive performance but lagged the sector as a whole because upstream energy producers and higher beta services names benefited from continued commodity price gains. Refining and marketing and drilling subgroups are down year-to-date.
SECTOR DRIVERS AND THEMES FOR 2017 Throughout 2016, the market values of energy equities have been led by a price recovery in oil, natural gas, and coal. A long tail of higher than normal inventory levels has put pressure on select sub-industries such as refining and offshore drilling. Another theme in 2016 was the delineation of acreage in the U.S. oil and natural gas shale basins. Companies operating in the Permian, STACK, and Marcellus/Utica shale basins received the most attention. In 2017, we believe commodity prices will be choppy and range bound with only modest upside potential. Therefore, we believe investors will continue to reward producers that can deliver production growth at current commodity prices, all the while keeping leverage in check.
2016 Price Index of Oil, Natural Gas, and Coal 1.8 1.65
Price Index (1.0 = 12/31/2015)
1.6 1.37 1.34
1.4 1.2
It was created by benchmarking the included price sets to 1.0 as of December 31, 2015, and changing the index values based on monthly percent price changes.
1.0 0.8 0.6 Dec 2015
Source: The price index is an internal creation and is as of October 20, 2016.
Jan 2016
Feb 2016
Mar 2016
Apr 2016
Oil (WTI)
Natural Gas (Henry Hub)
– –
May 2016
–
June 2016
Jule 2016
Coal (Argus McCloskey)
Aug 2016
Sept 2016
E.g. a 1% price change is represented through the formula (Index T+0 * (1 + .01)) = Index T+1. Data supplied by FactSet
WHERE TO INVEST IN 2017 We continue to favor large cap integrated oil companies and POTENTIAL TAILWINDS & HEADWINDS midstream MLPs, given their relatively more stable cash flows, high yields, and the expected continued commodity price recovery. The biggest potential tailwind to our recommendations is oil and While integrated oil companies and midstream MLPs are destined natural gas prices. Ironically, lower for longer prices would likely to underperform the broader energy sector in periods of rapidly support our weighting on a relative basis, given our preference for rising commodity prices, the relative stability of distributions should lower beta IOCs and midstream MLPs. However, the energy sector interest yield seeking investors. For more direct commodity price as a whole is likely to outperform if energy commodity prices exposure, we maintain our positive outlook on well capitalized, are strong. upstream exploration and production names operating in low cost U.S. shale basins. Producers in the U.S. in particular have benefited from dramatic declines in the cost of production, which has increased the net asset value (NAV) estimates of resource bases, and is increasingly driving stepped up drilling activity. Finally, we are incrementally more constructive on oilfield services names because the improved outlook for energy demand is starting to drive a recovery in exploration activity, particularly in low cost regions such as the North American land market. As has been the case for the last two years, we remain less favorable to exploration and production names with high cost production, limited financial flexibility, and the need for ongoing gains in commodity prices to survive, particularly upstream MLPs. We also remain less favorable to the offshore drilling and oil tanker and marine MLP sub-groups. Both continue to suffer from chronic oversupply and even in the event of an end market recovery we see low visibility to sustained strong returns on capital among these industries.
4
2017 EQUITY SECTOR OUTLOOK
FINANCIALS 2016 Performance Through the first nine months of 2016 the Financial sector was the second to last performer in the S&P 500, however, during the first two weeks of November, Financials rallied to become the third best performing sector. The meaningful turnaround is related to rising rates, particularly in longer duration bonds, resulting in a steeper yield curve. Interest rates have increased meaningfully after the 2016 presidential election which may lead to a potentially more favorable view of rate sensitive industries. A slow and measured pace of interest rate increases is supportive of industries with low interest rate sensitivity, including non-life insurance companies.
%
SECTOR DRIVERS AND THEMES FOR 2017 Interest rates play an important role in Financial sector performance and are the primary driver of investor returns in this low rate environment. Interest rates may likely continue to drive sentiment for the sector with transitory fits-and-starts but the outlook is structurally lower rates for an extended time period. We believe that financial technology (fin-tech) is increasing in strategic importance and disruptive ideas such as blockchain could show real capabilities. Regulation could play a meaningful role in sector performance in 2017. Financial companies may be granted the authority to return excess capital back to shareholders allowing for higher returns on equity if the recently elected politicians were to pare back regulatory burdens. In our view, domestic banks are increasingly likely to take market share from European banks.
Large-Capitalization Financial Stocks Correlation of Relative Returns with the Total Return of Ten-Year Treasury Bonds 1 1929 Through September 2016
100 80 Correlation Coefficient
60 40 20 0 (20) (40) (60) (80)
Sector performance is negatively correlated with bond prices; correlation is a statistical measure that describes the degree of association between two variables (bond prices & stock prices). It does not measure the magnitude of that association. There is no guarantee that historically low or non-correlation will continue in the future. Past performance is no guarantee of future 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 13 16 results. Bond prices move inversely to Shade reflects recessionary periods changes in interest rates.
Source: Bloomberg L.P., National Bureau of Economic Research, Empirical Research Partners Analysis, Wells Fargo Advisors. As of September, 2016. 1 Constructed using large-cap stocks as defined by greater than $10B market capitalization with trailing two-year data capitalization-weighted returns; on trailing three months basis, prior to 1978 the long bond is used.
WHERE TO INVEST IN 2017 Financials are no longer one of the largest sectors in the S&P 500 due to POTENTIAL TAILWINDS & HEADWINDS the recent divestiture of the real estate industry which became its own sector in 2016. Banks and insurance companies now comprise nearly Interest rate sensitive industries have significantly reduced costs two-thirds of the weighting for the Financial sector. over the past few years and therefore could experience a significant We recommend a barbell allocation in terms of high versus low interest earnings benefit if interest rates were to increase more than expected. New regulations including the Department of Labor rate sensitive industries. At one end of the barbell we recommend fiduciary standards rule could have a meaningful impact on many interest rate sensitive industries with a bias toward life insurance. On asset managers and brokerage industries. Smaller companies with the other end of the barbell we continue to recommend low-interest rate sensitive industries including property and casualty and insurance limited resources and manager underperformance may decide to explore strategic alternatives. brokers, as well as some of the exchanges. There has been significant money flows out of active and into passive management strategies. We view this trend, combined with the potential for new regulation, as an overall negative for the asset management industry but we believe select opportunities do exist. Low market volatility has been unprecedented over the last few years. To the extent volatility normalizes, we recommend selective positioning in exchanges. Banks have a relatively high sensitivity to interest rates, especially the regional banks due to their outsized revenue tied to net interest margins. From a valuation perspective, banks appear to be largely in line with historical levels and we are less inclined to recommend this cohort given the regulatory burden associated with limited capital return to shareholders in the form of share repurchases and dividends. Within banks we prefer select large-cap diversified banks with broad based revenue streams that can generate returns in excess of their cost of capital. 5
2017 EQUITY SECTOR OUTLOOK
HEALTH CARE SECTOR DRIVERS AND THEMES FOR 2017 Pharmaceutical pricing issues have taken center stage, causing a rippling effect across many of the sub-industries. During the second half of the year there was a lot of energy in Washington surrounding the elections, including fixes and changes to the Affordable Care Act (ACA) and potential legislation aimed at pharmaceutical price controls. Although we believe there will continue to be an effort to deal with egregious pricing actions through legislation, we anticipate efforts by the next presidential administration regarding health care reform fixes and actions will initially be highly uncertain— which may create volatility for many sub-industries within health care. We anticipate M&A will continue to be an important theme going forward, particularly within the pharmaceutical and biotechnology sub-industries.
2016 Performance The Health Care sector has been one of the worst performing sectors of the S&P 500 in 2016. Investor rotation out of health care and into other sectors, along with regulatory and political rhetoric, has been weighing on companies within the sector, notwithstanding an active Merger and Acquisition (M&A) environment. We believe that drug pricing concerns, mergers and acquisitions and sector rotation will continue to contribute to volatility in the sector.
Growth of Prescription Drug Expenditures and National Health Care Spending Through 2025 (Year-over-year % change; actuals through 2014) 14% 12.2%
12%
8.5%
8.1%
8%
6.4% 6.5%
6.0%
6.3%
6%
6.4%
6.8% 6.7%
6.8%
4.7%
4% 2.2%
Health Care
2025
2024
2023
2022
2021
2020
2019
2018
–
2017
2016
–
2015
2013
2009
2008
0.2%
2012
0.1%
0%
2.4%
2014
2.5%
2011
2%
2010
Percent Annual Growth Rate
10%
Prescription Medicines
According to the Center of Medicare & Medicaid Services (CMS) prescription drug expenditures are anticipated to grow in line with the National Health Care Spending. On average, prescription drugs are anticipated to grow by 6.8%, as compared to the National Health Care Spending growth of 5.8%.
Source: Center for Medicare & Medicaid Services (CMS), CMS National Health Expenditure Report, July 2016
WHERE TO INVEST IN 2017 We anticipate companies will continue to use spin-offs and M&A as a form of refocusing businesses internally and as a way to unlock POTENTIAL TAILWINDS & HEADWINDS value in non-core businesses. Many companies are in need of filling Catalysts for the sector will take the form of new product approvals pipelines with new product opportunities, and we believe the appetite and data flow resulting from pharmaceutical, biotechnology and for M&A within the bio-pharma sub-industries will continue in medical device product research. We believe M&A will become 2017. Although grappling with pricing issues up to this point, we more company specific and focused as we head into 2017. anticipate that, in general, the new Administration will be friendlier On the flip side, we could see some significant headwinds in to the pharmaceutical sub-industry in 2017; we would expect any particular as it relates to clarity behind a “repeal and replace” for legislation aimed at the pharmaceutical pricing to be limited to the ACA, and more, specifically as it relates to rhetoric pertaining protecting consumers from egregious price increases and not be a to pharmaceutical product pricing. broad-based policy. Ultimately, we believe the opportunity within the pharmaceutical industry will be based on a continued focus on streamlining core businesses and fueling a renewed research and development (R&D) wave. The medical equipment sub-industry has the ability to continue to lead in terms of performance relative to the S&P 500 in 2017, but the uncertainty regarding the new administration may cause some volatility for this sub-industry — at least until a path to “repeal and replace” of ACA is made clearer. In terms of sub-industries within the sector that may be negatively affected by a new Administration, we believe health care service companies that have benefited from the increase in covered lives due to the ACA — such as health care facilities, laboratories, and managed care organizations, will exhibit the most volatility and initial weakness to the uncertainty the election results bring to these sub-industries. Yet, within the managed care sub-industry, we continue to like the big diversified managed care companies that are not heavily levered to the ACA public exchanges. 6
2017 EQUITY SECTOR OUTLOOK
INDUSTRIALS 2016 Performance The total return of S&P 500 Industrial sector modestly exceeded the S&P 500 total return through the first nine months of 2016. We attribute the Industrial sector performance in part to investor demand for dividendpaying equities given the relatively high dividend yields of many industrial companies. Additionally, certain industrial companies derive a significant portion of their revenue from energy-related customers and these industrial companies may be benefitting from investors seeking to profit from future higher oil prices.
SECTOR DRIVERS AND THEMES FOR 2017 Key themes influencing the industrial sector in 2017 will likely include: the pace of global economic growth in larger markets, trends in capital spending by consumers, companies and governments, modestly higher oil prices, and the continuing convergence of technology within the Industrial sector. In the near-term, we expect technology to remain a major theme as many industrial product and service offerings are utilizing increasing amounts of data for applications such as predictive maintenance schedules and optimization and reliability management. Additionally, technological advances are being utilized to improve manufacturing processes across many different businesses.
U.S. Industrial Production Index 110 105 100 95 Index Level
90 85 80
Industrial production has recovered after the 2008-2009 recession, but has flattened out as U.S. growth has moderated. Improvement in economic conditions will likely be needed to reverse recent declines.
75 70 65 Oct 1, 1990 Jun 1, 1991 Feb 1, 1992 Oct 1, 1992 Jun 1, 1993 Feb 1, 1994 Oct 1, 1994 Jun 1, 1995 Feb 1, 1996 Oct 1, 1996 Jun 1, 1995 Feb 1, 1996 Oct 1, 1996 Jun 1, 1997 Feb 1, 1998 Oct 1, 1998 Jun 1, 1999 Feb 1, 2000 Oct 1, 2000 Jun 1, 2001 Feb 1, 2002 Oct 1, 2002 Jun 1, 2003 Feb 1, 2004 Oct 1, 2004 Jun 1, 2005 Feb 1, 2006 Oct 1, 2006 Jun 1, 2007 Feb 1, 2008 Oct 1, 2008 Jun 1, 2009 Feb 1, 2010 Oct 1, 2010 Jun 1, 2011 Feb 1, 2012 Oct 1, 2012 Jun 1, 2013 Feb 1, 2014 Oct 1, 2014 Jun 1, 2015 Feb 1, 2016 Oct 30, 2016
60
Source: Bloomberg, Board of Governors of the Federal Reserve System
WHERE TO INVEST IN 2017 We continue to favor industrial companies that generate a significant portion of their revenue from the U.S. given projections that U.S. economic growth is likely to lead all developed markets over the next year. We prefer companies with a strong U.S. presence and a diversified business mix with a number of well-respected and recognizable brands. The transportation group is a sub-industry within Industrials that may be challenged in 2017. Shipping demand in both the rails and the trucking industries remains weak and the trucking industry is also working through fleet overcapacity issues along with limited pricing power. Another sub-industry that may also face challenges in 2017 is machinery, specifically companies that manufacture larger commercial equipment. A combination of large fleets of used equipment, weaker demand from core customers and the stronger U.S. dollar may continue to weigh on sales volumes.
POTENTIAL TAILWINDS & HEADWINDS Potential catalysts for companies in the Industrial sector include acceleration of global economic growth, an increase in corporate and government capital investment, moderation in the strength of the U.S. dollar and an increase in merger and acquisition activity. Possible headwinds to the Industrial sector include a continuation of weak global economic growth, stagnant levels of capital spending, additional geopolitical turmoil and lower consumer consumption resulting from weak economic growth.
7
2017 EQUITY SECTOR OUTLOOK
INFORMATION TECHNOLOGY SECTOR DRIVERS AND THEMES FOR 2017 Although details around President-elect Trump’s agenda are largely unknown, policy restrictions on immigration and trade could have negative effects on the Technology sector. Many US companies import components from overseas, and increased costs due to tariffs or taxes could compress margins while making goods more costly. Technology firms have long been reliant on foreign visa programs to hire specialized talent. Substantial restrictions would likely increase R&D expenses and, slow the pace of development for new technologies, including IoT, virtual reality, and artificial intelligence. Global IT spending is forecast to expand modestly in 2017, mostly driven by spending on cloud software and IT services. Security will likely become a top priority due to the increasing number of connected devices and complex threats. Firms are reducing the number of vendors they purchase from and we expect some consolidation within the security software industry. 2016 Performance Technology has been one of the top performing sectors within the S&P through the end of the third quarter, handily outperforming the S&P 500 Index. At the beginning of 2016, we opined that some of the best opportunities existed within the semiconductor markets with exposure to the cloud. More specifically, we expected semiconductor equipment spending would accelerate throughout the year. So far, the semiconductor industry has been the best performing group within the Technology sector.
Global IT Spending Expected to Rebound 4,000 Annual IT Spending (in Billions USD$)
3,500
n Telecom Services
3,000
n IT Services
2,500
n Enterprise Software
2,000
n Data Center Systems
1,500
n Devices
1,000 500 0
2012
2013
2014
2015
2016E
2017E
Following modest declines the past couple years, Global IT spending is forecast to expand modestly in 2017, mostly driven by spending on software and IT services (Source: Gartner Inc.). Brexit is the likely source of the modest dip in 2016, as companies took a minor pause in their long-term IT spending strategy. This break elongated the sales cycle as firms explore all viable options, yet IT spending should accelerate over the next 12 months.
Source: Wells Fargo Advisors, Gartner, Inc., Bloomberg
WHERE TO INVEST IN 2017 We anticipate spending on semiconductors to continue expanding POTENTIAL TAILWINDS & HEADWINDS in 2017, but the pace of growth may begin to slow. To be clear, we do Technology companies generate a significant amount of revenue expect growth from semiconductors, but the industry will likely face difficult year-over-year comparisons next year. We continue to favor internationally and may be negatively affected by a persistently Semiconductor companies with exposure to the automotive industry stronger US dollar. Brexit has caused an elongation of the purchase as the amount of digital content inside the vehicle should increase cycle (notably in Europe). Companies are evaluating viable options dramatically over the next few years including features such as complex outside the UK before making long-term decisions. advanced driver assist systems (ADAS), in-vehicle connectivity, and Emerging markets have been significant contributors of growth for infotainment systems. many technology firms, and reacceleration of these markets could Semiconductor companies that produce commoditized chips are likely provide a tailwind. Smartphone growth has slowed over the past to trade lower in the short term due to potential trade restrictions implemented by the incoming administration. However, Semiconductor couple years as consumers are holding onto their devices longer and extending the replacement cycle. However, the sector may benefit firms that supply specialized chips for cutting-edge applications, from the shift to mobile and growing acceptance of social media. such as artificial intelligence and autonomous cars will likely fare much better. Companies related to the cloud, search and advertising and streaming media should benefit from the shift to mobile. Firms that boast dominant social media platforms and a loyal engaged customer base should benefit from this trend. An expanding social media user base creates additional advertisement opportunities, as users are constantly connected with their mobile devices. Although smartphone growth has been slowing the past few years, the trend may reverse if consumers feel compelled to upgrade to take advantage of some new technologies like augmented/virtual reality, wireless charging and OLED screens on a larger scale. The network will also need to be improved. Some of the groundwork has already begun, but the build out should accelerate next year. Many firms have targeted the large scale rollout of the fifth generation network (5G) to coincide with the 2018 Olympics. 8
2017 EQUITY SECTOR OUTLOOK
MATERIALS SECTOR DRIVERS AND THEMES FOR 2017 The Materials sector is driven in large part by the global commodity prices underlying the different sub-industries in the sector. Commodity prices, in turn, are driven by the different supply and demand dynamics specific to the different commodities. During the majority of 2016, supply and demand dynamics were more favorable, pushing prices upward and having a positive effect on the sector. The effect of global commodity trading is an important factor to consider as increases in capacity world-wide can result in increased supply, such as the case of China with relation to some commodities. Slowing growth in China, one of the biggest consumers of basic metals, has slowed the growth and demand for many of the sub-industries within the sector.
2016 Performance The Materials sector outperformed the S&P 500 during the majority of 2016. Commodity prices rebounded from the drops seen throughout 2015 that extended through the better part of January 2016. The sector’s performance was driven by strength in the metals and mining and chemical industry groups. We anticipate continued volatility in 2017 in line with the underlying commodities as the commodity super cycle down market continues.
S&P 500 Materials Index vs S&P GSCI ™ Daily 130 125 120 115 Index Level
110 105 100 95 90 85
Dec 2015
Jan 2016
Feb
Mar
–
Apr
May
Jun
S&P 500 / Materials - Price (Left)
–
Jul
Aug
Sep
S&P GSCITM (Right)
Oct
Nov 2016
Past performance is no gurantee of future results. S&P 500 Materials Index comprises those companies included in the S&P 500 that are classified as members of the GICS® materials sector. S&P GSCI serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. It is a tradable index that is readily available to market participants of the Chicago Mercantile Exchange. The index was originally developed by Goldman Sachs.
The Materials sector has benefited from an increase in commodity prices in 2016. We do not anticipate that trend to hold long-term, given that commodities remain in a multiyear bear super-cycle. A bear super-cycle is an extended period of time of downside pressure to commodity prices.
Source: FactSet and Wells Fargo Advisors
WHERE TO INVEST IN 2017 We remain positive in the non-commodity sub-industries of the POTENTIAL TAILWINDS & HEADWINDS sector as they tend to exhibit less volatility than the commodity-tied counterparts, in particular those within the non-commodity chemicals Due to exposure to commodity prices, we expect higher volatility industry group. This group includes the specialty chemicals, industrial than the market, characteristic of the Materials sector. Increases gases and agriculture firms. The specialty chemicals and industrial and/or recovery in pricing within the oil, natural gas, gold, silver, gases sub-industries benefit from the demand within the production copper and other metals should positively impact the sector. chain, usually integral and value-add inputs for clients’ end products. Economic trends world-wide are important factors affecting The industrial gases companies produce fairly steady results given the Materials sector, particularly as it relates to the economy in the long-term contract nature of their business relationships as China. An increasing softness in GDP growth in China can produce they provide the gases required to run client facilities. Finally, the additional volatility as demand for metals adjusts downward. agriculture companies produce crop chemicals, nutrients, seeds and/ or provide farmer assistance finding the optimal combination of products for a given region’s soil and climate. We believe that the long-term trends in population and income growth should also support demand expansion. In particular, the expectations of China evolving from a manufacturing/building economy to that of a service economy will benefit the consumable commodities and in turn the agricultural sub-industries. We continue to view less favorably sub-industries with direct exposure to the underlying commodity pricing swings, namely the basic metal and mining sub-industries. Although these sub-industries have performed well as commodity prices bounced back, we anticipate seeing volatility characteristic to these industries. Commodity strategists anticipate the base metals to remain in an extended volatile market as they remain in the bear stage of the commodity super-cycle. 9
2017 EQUITY SECTOR OUTLOOK
REAL ESTATE 2016 Performance The Real Estate sector was added as the 11th sector by S&P on August 31, 2016 and is comprised of 27 Real Estate Investment Trusts (REITs) and one non-REIT real estate company. The total return of S&P 500 Real Estate sector was essentially equal to the S&P 500 total return through the first nine months of 2016. We attribute the 2016 real estate sector performance in part to investor demand for dividend-paying equities given the higher common dividend yields of many REITs.
SECTOR DRIVERS AND THEMES FOR 2017 We believe a significant influence on 2017 REIT total returns will be the interest rate environment and the reaction to rate increases. While we feel an environment where the Federal Reserve is raising interest rates in a measured approach would be accompanied by reasonable economic and job growth (and this would be a positive operating environment for REITs), we note in 2013 and 2015 REITs generated relatively weak total returns. Both of these periods were when the Federal Reserve discussed or implemented a rate increase. Another major factor will likely be the ability of REITs to identify and access attractively priced capital to fund property acquisitions and developments.
FTSE NAREIT US Real Estate Index (Total returns in percent) 35.7
37.1
35.3 19.7
35.1
31.6
26.4
28.0
18.1
20.3 15.3
14.6
13.9
3.2
12.2
8.3
3.8
-4.6
-15.4
30.1
28.0
3.2
2.5
REIT total returns have generally been positive following 2008, but have lagged the broader market when investors have anticipated interest rate increases
-15.7
-17.5
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
-37.7
Past performance is no guarantee of future results. An index is unmanaged and not available for direct invetment. Source: National Association of Real Estate Investment Trusts; returns as of Dec. 31, 2015
WHERE TO INVEST IN 2017 REITs that may outperform during the anticipated low economic POTENTIAL TAILWINDS & HEADWINDS growth and modest inflationary environment have longer lease terms or healthier earnings growth prospects that could generate We feel REITs could generate relatively attractive total returns more robust returns. Industries with longer lease terms would should the Federal Reserve ultimately implement two modest include health care, freestanding retail/net lease, and certain retail interest rate increases over the next year as many investors expect. categories. On the earnings growth front, we expect specialty REITs However, if interest rates rise faster than anticipated, REITs would (particularly technology-related REITs such as cell tower and data likely underperform the broader market assuming investors rotate center REITs) and industrial REITs to produce strong growth due to into investments that could provide higher levels of income. robust underlying demand from their tenants. Conversely, segments The pace of U.S. economic growth will also likely influence REIT with shorter lease terms such as hotels, apartments, and self-storage earnings, dividend, and share price growth. A continuation of the may lag the Real Estate sector if economic growth and inflation current sluggish economic growth trajectory will likely moderate remain subdued. Self-storage and apartment REITs have generated REIT earnings growth but could also result in interest rates solid revenue growth over the last few years and both have witnessed remaining low. increases in new property development, however, we feel these factors may serve to moderate near-term earnings growth for companies in these two property segments. During the time period of 2012-2014, corporate profits and U.S. job growth improved, allowing hotel and lodging REITs to generate attractive total returns. Moderating growth of these two important hotel demand drivers, along with rising new hotel construction, has resulted in a weaker outlook for near-term hotel REIT earnings growth. However, we would also note that hotel occupancy rates are near all-time highs and material improvements in corporate profits, employment, or overall economic growth could generate a quick recovery in hotel REIT earnings and total returns. 10
2017 EQUITY SECTOR OUTLOOK
TELECOMMUNICATIONS SERVICES 2016 Performance In 2016, we suggested Telecommunications (Telecom) investors focus primarily on the large national carriers with diverse revenue streams – essentially narrowing the field to the top two companies in the sector. Additional exposure was suggested in the tower companies for highergrowth accounts. This approach largely matched the sector’s high single digit return through the third quarter. Broadly, wireless outperformed the towers which outperformed wireline.
SECTOR DRIVERS AND THEMES FOR 2017 The top drivers in the Telecommunications (Telecom) sector remain the same — competition, regulation, and dividend yields. In wireless, the two incumbents have been feeling pressure in the segment as competitor efforts have resonated with consumers, particularly around data pricing. The regulatory picture remains unclear. Challenges to net neutrality rules are still working through the legal system and will likely still be outstanding in 2017 but news flow could affect stocks in the sector. Additionally, the Federal Communications Commission (FCC) is weighing new rules related to business data services and the industry largely views this as a negative development. Finally, as the highest yielding sector in the equity market, the Telecom sector will remain sensitive to changes in interest rates which could provide a tailwind or a headwind.
Estimated U.S. Monthly Mobile Data Traffic 3.5 3.0
Mobile data traffic is expected to continue to grow significantly into 2020 as estimated by Cisco. This growth affects the Telecom sector in several ways: Carriers need to continually invest in networks to meet customer demand, a draw on carrier cash flow but a potential positive for the tower companies. Data pricing and the network experience will be differentiators among the carriers.
2.5
Exabytes*
2.0 1.5 1.0 0.5 0.0
2015
2016
2017
2018
2019
2020
Year
Source: Cisco and Wells Fargo Advisors.
WHERE TO INVEST IN 2017 We believe the large diverse carriers are appropriate as the POTENTIAL TAILWINDS & HEADWINDS cornerstone of an investor’s Telecom exposure and view the tower companies as attractive alternatives for higher-growth accounts. The attractive dividends paid by most telecom stocks make them We are less favorable toward wireline-specific carriers because sensitive to interest rate movements, and rate expectations will this segment could see more volatility related to regulations and affect the sector’s performance. Competition in wireless has picked rate increases. up recently as the number three carrier has made great strides in its marketing messaging and subscriber additions. Additionally, Large carriers have offered attractive dividend income, diverse the number four carrier has been improving its financial stability revenue sources, and relatively stable total return profiles. They have and adding subscribers to its improving network. Thus far, the taken actions to defend share and maintain their core subscribers industry has remained rational but more aggressive pricing actions while at the same time ceding some lower profit customers. We expect could disrupt profitability. these trends to continue and potentially accelerate. The key benefit of the large operators is that they are also the most diverse offering TV, broadband, and other services to individuals as well as businesses and enterprise network services. While the wireless side may experience pricing pressure, other growth opportunities exist within product portfolios. We suggest using the tower companies as complimentary positions due to their higher expected growth and carrieragnostic exposure to the wireless segment. Two of the three publicly traded tower companies are organized as real estate investment trusts (REITs) so technically they fall under the Real Estate sector. Further, the tower companies’ business mixes vary by geography, technology and carrier exposures, while dividend yields and risk profiles are similarly diverse. We believe the tower companies offer an attractive way to participate in the robust growth of data consumption both domestically and abroad without the need to pick the “winner” among the carriers. *The exabyte is a multiple of the unit byte for digital information. The prefix exa indicates multiplication by the sixth power of 1000 (10¹⁸) in the International System of Units (SI). Therefore, one exabyte is one quintillion bytes (short scale). The symbol for the exabyte is EB.
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2017 EQUITY SECTOR OUTLOOK
UTILITIES 2016 Performance 2016 has been a roller coaster for the Utilities sector. The first half of the year saw significant outperformance but the sector has moved lower since, narrowing the outperformance gap to the market. Our recommendation to focus on regulated electric or gas utilities has performed largely in line with the sector. The outliers in the sector were independent power producers to the upside and water utilities to the downside.
SECTOR DRIVERS AND THEMES FOR 2017 The Utilities sector remains highly sensitive to interest rate expectations. This will likely continue into 2017 as the Fed contemplates rate increases and the market anticipates the timing of changes. We believe interest rate expectations will be the top driver of the sector in 2017 but we are uncertain if this will end up being positive or negative. Merger and acquisition (M&A) activity will remain a driver as the bigger electrics have been eyeing smaller gas companies to boost their growth profiles given long capex backlogs. This activity may slow, however, if the financing environment becomes less accommodative. Additionally, pipelines, a growth driver for gas utilities, remain in the headlines due to several announcements related to delays or cancellations to planned routes.
310
3.2
300
3.0
290
2.8
280
2.6
270
2.4
260
2.2
250
2.0
240
1.8
230
1.6
220
1.4
210
Sept 2013
Dec 2013
–
Mar 2014
June 2014
Sept 2014
Dec 2014
Mar 2015
Jun 2015
S&P Composite 1500 / Utilities – Price (left axis is index level )
Sept 2015
–
Dec 2015
Mar 2016
June 2016
June 2016
% Yield
Index Level
Utilities Sector vs. 10-year U.S. Treasury Yield
Utilities stock prices move with interest rates, in this case the 10-year U.S. Treasury.
1.2
Dec 2016
US Govt Yield – 10 Yr (right axis is % yield)
Yields represent past performance. Past performance is no guarantee of future results. Yields will fluctuate as market conditions change. Current yields may be higher or lower than that quoted. The S&P Composite 1500® Utilities Index comprises those companies included in the S&P Composite 1500 that are classified as members of the GICS® utilities sector. Source: FactSet and Wells Fargo Advisors
WHERE TO INVEST IN 2017 For 2017, we recommend investors focus Utilities exposure on POTENTIAL TAILWINDS & HEADWINDS regulated names with the potential for above-sector dividend growth of about +5%. We believe utilities with the ability to increase dividend The attractive and reliable dividends paid by many utility stocks rates at above average levels will likely perform well relative to make them sensitive to interest rate movements, particularly in peers against the backdrop of a rising interest rate environment. In the current low rate environment. Interest rate increases could a rising rate environment we expect utility stock prices to decline, negatively affect the sector on a short term basis as the dividend bringing elevated valuation multiples down and pushing dividend yields could become less attractive relative to other income yields up. The valuation multiple is purely market driven, meaning a producing securities (i.e. bonds) and lead to a rotation out of utility management team cannot influence it but management can influence stocks. A prolonged environment of benign interest rates and the stock’s dividend yield. We believe a rising dividend will lessen the expectations could provide support or potentially increased demand pressure on the stock price as it further increases the yield beyond for the stocks. just the price decline. In a perfect world the math would simply work in this fashion, however, market sentiment would probably pull the multiple down on the stocks as well so the dividend increase would not likely fully offset the difference but we believe the rising dividend would provide support. Within this framework, we see opportunities in electric, gas and multi-utilities with lower confidence in independent producers. We note, however, valuations in the space remain high relative to historical levels with dividend yields and earnings multiples premiums across the traditional electric, gas, water, and multi-utility industries. 12
HEALTH CARE
FINANCIALS
ENERGY
CONSUMER STAPLES
CONSUMER DISCRETIONARY
VALUATIONS & RISKS
2017 EQUITY SECTOR OUTLOOK
» The Consumer Discretionary sector currently trades at 17.27x the next twelve months (NTM) consensus estimate of $35.96. The current price to earnings (P/E) ratio is slightly above the five-year historical valuation of 17.07x. Relative to the S&P 500, the Consumer Discretionary sector is trading at 1.06x, which is slightly below historical levels of 1.15x. We see the absolute premium for the group a function of the numerous tailwinds that are aligning up to further accelerate consumer spending trends throughout 2016. The consensus estimates reflect earnings per share (EPS) to increase 13.3% in 2016 compared to the EPS increase of 12.6% in 2015. » Risk considerations for the Consumer Discretionary sector include (1) apparel price deflation due to low-cost entries, high inventory levels and pressure from e-commerce players, (2) reduction in traditional advertising dollars as social media ad spending increases, (3) continued tight access to credit that could limit larger discretionary purchases, (4) declining consumer acceptance of new product introductions, and (5) geopolitical risks, including a large-scale terrorist incident that could impact consumer psyche. » The Consumer Staples sector currently trades at 19.62x the NTM consensus estimate of $27.61. The current P/E ratio is above the five-year historical valuation of 17.75x. Relative to the S&P 500, the Consumer Staples sector is trading at 1.20x, which is mostly in line with historical levels of 1.19x. We believe the absolute premium is due to investors utilizing this sector as a perceived alternative equity safe-haven for yield relative to traditional fixed-income instruments. The consensus estimates reflect EPS to increase 4.7% in 2016 compared to the EPS decrease of -.5% in 2015. » Risk considerations for the Consumer Staples sector include a softer macro environment, intense competition, customer concentration, availability and cost of raw materials, consumer acceptance of new product innovations, and complexities associated with acquisitions. In addition, a perceived increase in real interest rates could impact investor sentiment towards the Consumer Staples segment, as investors, over recent years, have used this sector as a perceived safe-haven yield alternative to traditional fixed-income vehicles during the low interest rate environment. » The energy sector is currently trading at price-to-book value (P/B) of 1.82x. The current P/B ratio is below the fiveyear average for the group of 1.80x. Relative to the S&P 500, the energy sector has been trading at 0.72x, below the five-year historical average of 0.77x. The weaker ratio is due to the contraction in both sector equity prices and average book values. » Risks include weakness in the economy world-wide, commodity price exposure, slow macro-economic recovery, reserve replacement, exploration risk, and a slow approval process for liquid natural gas (LNG) projects by regulatory and government agencies. Additionally, MLPs can be exposed to volumetric risk, commodity price exposure, potential customer concentration risks, asset depletion, and even seasonality in the case of propane.
» The Financial sector currently trades at 12.23x the NTM consensus EPS estimate of $26.82. The P/E ratio reflects a premium compared with the 5 year historical valuation of 12.14x. Relative to the S&P 500, the Financial sector is trading at 0.75x times compared to historical levels of 0.82x. We believe the historical relative discount is due to higher leverage and regulatory burdens. The consensus estimates reflect EPS to increase 2.1% in 2016 compared to the EPS increase of 10.0% in 2015. » When investing in the financial sector investors must be mindful of macro risks which include general economic weakness which can lead to higher credit losses. Generally speaking, lower interest rates lead to a reduction in profitability. Capital market weakness can also lead to lower returns due to reduced assets under management as well as constraints around accessing the markets for growth capital. » The health care sector is currently trading at 14.03x the NTM consensus EPS estimate of $55.57. The current P/E ratio is slightly above the five-year average for the group of 15.24x. Relative to the S&P 500, the health care sector has been trading at 0.86x, below the 1.02x five-year historical average level. The consensus estimates reflect EPS to increase 7.9% in 2016 compared to the EPS increase of 13.0% in 2015. » Risks to companies within the health care sector include competition on branded products, sales erosion due to cheaper versions (such as generic pharmaceuticals and/or biosimilar products), research & development risk, exposure to third party decision-makers such as the Food and Drug Administration on products anticipated to enter the market. Additionally, companies can be exposed to cuts in Medicare reimbursements (either based on yearly review or due to sequestration) as well as imposition of industry fees by the government as part of the Health Care Reform efforts in the U.S.
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UTILITIES
TELECOMMUNICATIONS
MATERIALS
INFO TECH
INDUSTRIALS
VALUATIONS & RISKS
2017 EQUITY SECTOR OUTLOOK
» The Industrials sector currently trades at 16.47x the NTM consensus estimate of $30.04. The current P/E ratio is above the five-year historical valuation of 14.92x. Relative to the S&P 500, the Industrial sector is trading at 1.01x, which is mostly in line with historical levels of 1.00x. The consensus estimates reflect EPS to increase 2.5% in 2016 compared to the EPS increase of 4.6% in 2015. » Key risks within the Industrial sector include the possibility of a worsening in the global economy, acquisition integration risk, operational issues, failure to introduce to market new and innovative products, further weakening in the oil market, potential price wars due to any excesses industry capacity, the impact of sequestration on U.S. defense spending and a sustained rise in the dollar, particularly versus the euro. » The Information Technology sector currently trades at 16.66x the NTM consensus EPS estimate of $48.12. The P/E ratio is above the 5-year historical valuation of 14.71x. Relative to the S&P 500, the Information Technology sector is trading at 1.02x, which is in line with historical levels of 0.99x. Analysts are expecting EPS to increase 2.1% this year compared to EPS increase of 8.7% in 2015. » When investing in Technology companies, please be mindful of increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products and the departure of key members of management.
» The Materials sector currently trades at 16.39x the NTM consensus EPS estimate of $17.94. This P/E ratio is modestly above the average 5-year historical valuation of 15.11x. Relative to the S&P 500, the sector is trading at 1.01x which is in line with historical levels of 1.01x. The consensus estimates reflect EPS to increase .4% in 2016 compared to EPS decrease of -4.1% in 2015. » The sector is sensitive to fluctuations in and relationships among commodity prices, particularly crude oil, natural gas and NGLs, metals, and agricultural products. China has been a major factor in driving demand and therefore pricing for many commodities. A global economic slowdown would weigh on the Materials sector’s performance. Many materials companies have significant operational exposure to foreign currencies. Additionally, many commodities are priced in U.S. dollars. Strength in the U.S. dollar could negatively impact reported results within the sector. » The Telecommunications Services sector currently trades at 12.57x the NTM consensus earnings per share estimate of $12.55; a significant discount to the sector’s average 5-year historical valuation of 14.88x. Relative to the S&P 500, the Telecom sector is trading at 0.77x times which is also at a discount to historical levels 1.02x. The sector’s current yield is 4.7%, well above the other nine S&P 500 sectors which makes it sensitive to interest rate increases. The Telecom sector is highly capital intensive as building and maintaining state-of-the-art networks requires significant capex. The consensus estimates reflect EPS to decrease by -4.7% in 2016 compared to the EPS increase of 21.3% in 2015. » Network performance, coverage, and reach are often the deciding factors when choosing a carrier and perceived weakness can affect customer metrics. Competition in all lines of the sector is formidable and varies based on region. Telecom companies are subject to thorough regulation at multiple levels. An adverse regulatory environment can stifle innovation and returns and add an element of uncertainty. » The Utilities sector currently trades at approximately 17.40x the NTM consensus EPS estimate of $14.41, which is modestly higher than its 5-year historical average of about 15.73x. Relative to the S&P 500, the Utilities sector is trading at 1.07x, largely in line with historical levels of 1.06x. Analysts are expecting EPS to increase 2.8% this year compared to EPS increase of 1.9% in 2015. The Utilities has paid an annual dividend of about 3.6%, compared to the yield of 2.3% within the S&P 500 Index. » Regulatory risk remains the key uncertainty for the Utilities sector, both at the federal and state levels. Additionally, Utilities typically carry high debt levels, and rising rates could impact their overall borrowing costs. High debt levels could also put a strain on credit ratings, which would also limit the ability to finance capital expenditures. As M&A activity increases, companies may face challenges when integrating those acquired businesses.
There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. 14
Index Definitions: An index is unmanaged and not available for direct investment. Industrial Production Index - The Industrial Production Index (IPI) is an economic indicator published by the Federal Reserve Board of the United States that measures the real production output of manufacturing, mining, and utilities. FTSE NAREIT US Real Estate Index - The FTSE NAREIT US Real Estate Index Series is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The FTSE NAREIT Equity REITs index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs.
Other Risk Considerations: Commodities: Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. In addition to the risks of investing in commodities generally, investing in base metals carries additional risks. These metals are highly levered to the relative strength of the U.S. dollar, economic growth and inflation. They cannot be held physically and are not easily converted to cash. Equity Securities: Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Investments in equity securities are generally more volatile than other types of securities. Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination. Foreign Investing: Investments in foreign securities entail special risks such as currency, political, economic, and different accounting standards. These risks are heightened in emerging markets. Growth and Value: Growth and value stocks may be more volatile than other stocks. The growth and value styles of investing cannot guarantee appreciation in the market value of a portfolio’s holdings. The growth and value types of investing tend to shift in and out of favor. Master Limited Partnerships: Master Limited Partnerships (MLPs) involve certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP. Real Estate: Investment in real estate securities have certain risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions. Sector Specific: Concentration in certain sectors may present more risks for a portfolio than if it was broadly diversified over numerous sectors of the economy. This will increase a portfolio’s vulnerability to any single economic, political or regulatory development affecting the sector and may result in greater price volatility. Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Investment Institute, Inc. (“WFII”) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. ©2016 Wells Fargo Clearing Services, LLC. All rights reserved. CAR #1116-04823
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