Those looking for an optimistic forecast for U.S. equities can turn to Northern Trust. Bob Browne, its chief investment officer, identified six themes that will drive the capital markets over the next five years. Taken together, they translate to 5.9% annual returns for U.S. stocks over that period, which includes 2017.

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Browne spoke at the Schwab IMPACT conference in Chicago on November 15. He oversees much of the $1.1 trillion under management at Northern Trust.

Browne predicted that developed markets, exclusive of the U.S., will earn 6.8% and emerging markets will return 8.4%. Because U.S. markets have returned so well this year, with equities returning approximately 17% year-to-date, he said we are “stealing future returns” in 2017.

How does he get 5.9% returns with PE ratios starting at approximately 20?

Browne said that revenue growth would contribute 4.3% annually (consisting of 2% from inflation and 2.3% from nominal GDP growth), 1.9% from dividends and 0.9% from enhanced margins and stock buybacks. Those numbers add up to 7.1%, but he applied a 1.2% “haircut” to account for valuations (PE ratios) “normalizing” to get to 5.9%.

Browne is not predicting a recession in the U.S. over the next five years.

He said the emerging market returns will be higher mostly because of stronger revenue growth at 6.7%.

Here are the six themes that Browne said should matter to investors:

  1. Entrenched growth – Economic expansion will continue globally, but at a modest rate by historical standards. Browne said that U.S. and other developed economies are in a growth “channel” and that means that there will be “fewer reasons to tighten monetary policy.” High debt levels will prevent a breakout to the upside, he said, and will keep monetary policy relatively easy.
  2. Waiting for monetary Godot – Browne said Beckett’s Waiting for Godot is a metaphor for the fact that those waiting for a return to the pre-crisis era of monetary policy will be disappointed. Instead, he said, the watchwords of monetary policy will be patience, gradualism and communication.
  3. Valuation superstructure – Browne said there is a structural reason why PE ratios should be higher, but not extremely higher, than historical averages. Industries such as information technology, consumer discretionary, healthcare and consumer staples should drive higher margins across the economy. Those industries went from 37% to 50% of the market in the last 10 years, he said, which explains 1.5% of the increase in PE ratios.

Browne showed a graph of 10-year Treasury yield versus the cash-flow yield for stocks (which he said is the best proxy for the value of equities):

U.S. equities

There is a strong linear relationship, Browne said. “Both are low by historical standards, as opposed to dot-com era, when cash-flow yields were lower than now despite higher Treasury yields.”

By Robert Huebscher, read the full article here.