Market Outlook: Equity Valuations Look Lofty

• The Morningstar Global Markets Index has returned more than 11.72% year to date and 18.68% over the past year.
• The market-cap-weighted price/fair value estimate ratio for our equity analysts' coverage universe is 1.05.
• Energy is currently the most undervalued sector, with a price/fair value estimate ratio of 0.96. Basic materials remains the most overvalued sector, with a price/fair value estimate ratio of 1.24.

In April Morningstar equity analysts began incorporating expected U.S. tax reform into valuation model assumptions. We currently believe that U.S. corporate tax reform is more likely than not to occur during the Trump administration, despite continued delays to the administration's agenda on other legislative items such as repeal of the Affordable Care Act.

The assumptions that we will use in our valuation models are based on Trump's and the House Republican plans but modified for what we believe are reasonable compromises needed for tax reform to occur. Most importantly, we are only incorporating a U.S. federal corporate tax cut down to 25% instead of 20% or 15%. As a reminder, the Trump administration's proposal calls for a 15% tax rate.

Our more shallow tax cut assumption when combined with our other policy assumptions make the reform package close to budget-neutral on a dynamic basis. Largely offsetting the federal revenue loss from the headline tax cut is the elimination of corporate tax credits (excluding research and development), a one-time tax revenue gain from a tax on cash held overseas, and additional tax revenue from near-term economic growth stimulated by tax reform.

Healthcare reform in the U.S. has dominated popular headlines. Our equity analysts' view is that should the Senate's healthcare bill become law, it should be a net positive for pharmaceutical and device firms and a mixed impact for hospitals and managed care firms. Pharmaceutical and device firms currently face various fees and taxes that would be eliminated under the proposed American Health Care Act, while hospitals and managed care firms could suffer from volume declines that would be offset by the eliminations of regulations and fees.

That said, there are challenges still to translating the House's and Senate's healthcare bill into law. The Senate Republicans' bill shares many similarities with the House GOP's, including the elimination of mandates, the option for states to redefine essential benefits, and a move toward capping Medicaid spending. Republicans control 52 seats in the Senate as well as the vice president's tie-breaking vote, but Republican senators from states that have expanded Medicaid face negative reactions from both constituents as well as governors that would oppose capping Medicaid. While Republican leaders want a vote on the bill as soon as possible, many individual senators are seeking delays so that they have time to assess the wisest move forward for their political careers.

In late May, OPEC and certain other countries agreed to extend their oil production cuts by nine months. The cuts makes sense, given that stocks within OECD countries are still 13% above the top of the 2010-14 range. Although the production cuts could help meet the objective of bringing inventories into the targeted range, the cartel might pay a steep long-term price for any near-term benefit.

Our equity analysts believe the cartel is underestimating the ability of shale producers in the U.S. to rapidly increase volumes in a $50-$55/bbl environment (West Texas Intermediate). Our energy sector team's 2018 and midcycle forecasts for WTI are still $45/bbl and $55/bbl, respectively, compared with spot prices around $44 per barrel these days.

Meanwhile, investor demand continues to prop up gold prices at $1,200 to $1,300 per ounce, with ETF gold holdings largely recovered to levels last seen before the December 2016 rate hike. But as the Federal Reserve continues to pursue rate increases, prices look primed to fall. Additional rate hikes by the Fed would further discourage investor flows into gold and have the potential to unleash accumulated ETF holdings back into the market, pressuring prices. Longer term, we're more optimistic, as we expect rising Chinese and Indian jewelry demand to fill the gap of shrinking investor demand for the yellow metal.

More Quarter-End Reports

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Credit Markets Credit Market Insights: Bond Indexes Perform Well in a Quiet Market

Equity Sectors Basic Materials Outlook: Propped Up and Too Expensive

Communication Services: AT&T and Verizon--A Duopoly No More

Consumer Cyclical: Amazon Reshapes Retail in Real Time

Consumer Defensive: Retailer Consolidation Sparks Concerns, but Opportunities Exist

Energy: Despite OPEC Cuts, a Crude Awakening Is Near at Hand

Financial Services: Our Take on U.S. Tax Reform and Bank Deregulation

Healthcare Outlook: ACA Repeal Efforts Unlikely to Yield Major Legislative Changes

Industrials: China Shows Signs of Softening, but the Sector Remains Healthy Overall

REITs: Some Scattered Opportunities in a Fairly Valued Sector

Tech: A Tectonic Shift Toward Enterprise Cloud Computing

Utilities: Tough to Stop This Sector's Powerful Performance

Mutual Funds First Half Winners and Losers for Funds

Second Quarter in U.S. Stock Funds: Growth on Fire

International-Stock Funds Continue to Prosper

Bonds in the Second Quarter: The Flattening

Portfolio Planning With Christine Benz Trends and Takeaways From 2017's First Half

PitchBook Reports Tapping the Brakes on M&A

Private Equity: Capital Deployment Remains a Challenge

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