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Market Commentary

Trump – calmer reflection, and opportunities

By November 25, 2016No Comments

“The problems of victory are more agreeable than those of defeat,
but they are no less difficult”

(Winston Churchill)

A large number of voters want change, and that is the Trump mandate – change. That is clearly a new political paradigm.

But is there a new economic paradigm? And to the extent that there might be, will it make much difference?

Trump might have a dream – but is it any more than a dream?

Tax reform, regulatory reform and fiscal stimulus (higher govt spending) are the three pillars which, in theory, should buoy economic growth and the stock market. Will they?

Can enough red tape be done away with to make a significant difference? The response of the bank stocks suggests yes, but it is very early days.

The intended spend on infrastructure is not that great (a trillion dollars over 10 years). It is a little more than Obama put in place, which had little economic impact – in fact this economic upswing (sic) has been the weakest in US history.

Another supposed pillar for the US stock market rising is the benefit from tax cuts which could boost earnings by about 8%. But what about the negative of higher interest rates, new trade barriers and the stronger dollar?

And more sober economists in the US (AKA Dave Rosenberg), have crunched the numbers and see no historical correlation between increased government spending and inflation or bond yields. Put another way, the market reaction of the last few weeks has no foundation in prior experience.

Most of the proposed tax cuts go to benefit the top 1%, so these tax savings will tend to be saved not spent. And for the 99%, you can expect a very large part of any saving to go to a mix of debt reduction and medical costs.

With larger tax cuts by Reagan in the early 1980s the economy was very slow to respond – and conditions then were considerably better (interest rates falling from high levels, much less debt, much younger population).

Bond yields have gone up (and bond prices down) because it is assumed that higher growth will be accompanied by higher inflation. Yet greater infrastructure spend in the 1930s, 1950, and after 9/11 did not raise inflation.

And, as Dave points out, if new infrastructure boosts productivity this is DEflationary, prices fall.

A stronger dollar and higher bond yields actually make it more difficult for the US economy e.g. remember that US mortgages are priced off bond yields, not like in the UK. So the market reactions so far have a DEflationary impact.

And for all the inflation talk, there is no sign of any in the US. Remember that there was supposed to be runaway inflation after QE was introduced, and the Obama stimulus announced in 2009 was going to create an inflationary boom – there was no inflation.

Obviously, it is unhelpful for the rest of the world that the US has growing protectionist tendencies (which, to be fair, were already underway globally). But in Asia they still understand the value of freer trade flows. While the TPP may now be dead from a US perspective, Asia ploughs on with its Regional Comprehensive Economic Partnership (RCEP), which doesn’t include the US but does include China.

Debt remains out of control in the US, as in much of the Western world. So while the markets have got excited about renewed growth, overwhelming and rising debt puts a big cap on any growth potential.

Here are some other thoughts including opportunities.

1. US valuations. Horrible.
The US stock market remains considerably over-valued (based on the long term measure which is the cyclically adjusted price/earnings ratio, or CAPE).

For example, S&P 500 cyclically adjusted price/earnings ratio (CAPE) is currently 26.6x vs. the average of 16.7x. It would need to fall 40% just to hit average.

Yet this over-valuation has been the case for a number of years, and it is unclear what will finally trigger a significant bear market, or when.

2. US earnings per share have been manipulated. Yuk.
We can define good debt as that which finances a project which generates a stream of income to pay the interest and eventually repay the capital. But a lot of current debt is not just unproductive but counter productive.

The best (worst?) example is the extent to which companies have borrowed money for what is politely termed “financial engineering” – less politely this is nothing more than senior executives lining their pockets.

According to Hoisington Investment Management, business debt increased by USD 793 billion last year, but only USD 93 billion was invested into the businesses to improve productivity and increase demand for labour. The other USD 700 billion went into lining executive pockets financial engineering, in particular share buybacks.

If a company buys back its own shares it increases the earnings per share – total earnings haven’t increased, but if there are less shares, the earnings per share go up. And would you be surprised if executive’s bonuses were based on the increase in earnings per share? No? You’re getting the picture.

3. US banks
Banks have been improving with Trump in mind. This assumes de-regulation and interest rates heading up. US banks are in better shape than their UK/European counterparts, with better balance sheets and lending outlook. But we can’t assume higher interest rates will hold.

4. How will US being protectionist hit rest of world?
One of the broad policies that Trump has focussed on has been to ‘put America first’. He is likely to seek to introduce protectionist policies that would have an impact on global trade. For example, he has indicated a desire to introduce a 35% import tariff on Mexican goods and 45% on Chinese goods. Protectionism is most likely to have an impact on companies in export nations in Asia and emerging markets. Mexico is very exposed.

5. US bond yields going up.
Much of what Trump discussed on the campaign trail – imposing tariffs, putting tax rates, building infrastructure – is seen as inflationary. It is assumed that Trump’s policies for growing the US economy through increased spending will have two impacts:

  • It will create inflation, which will push up yields
  • It will mean much greater bond issuance to finance the spending…

And yields will need to be higher to make those bonds more attractive to bond buyers. Higher yields mean lower bond prices. Are these assumptions reasonable? No one really knows.

The death of the bond bull market (now more than 30 years long) has been predicted for some years. Yet now we have a meltdown in parts of the bond market based on something which might happen, and even if it does, we don’t know precisely how.

For example, part of the reflation would (probably) be tax cuts. Well it took Reagan 4 years to push through tax reforms (and the US deficit, tax and unemployment rates were much more favourable back then).

And in the US, consumer and commercial lending is typically priced off bond yields. Which will push up the cost of borrowing, which is Deflationary.

So, it feels like the bond market has gone too far, too fast. But if you haven’t been reducing your exposure to bonds in recent years, don’t be panicked to get out now.

6. Opportunities: US small caps?
If Americans consume more domestically that is good for smallcaps. However, the strong dollar hurts any export markets. Plus, rising rates make raising finance more expensive, limiting investment/expansion. Perhaps there are selective opportunities in US small caps. But with heightened uncertainty in the US, investors don’t want to be over-exposed to US equities or bonds.

7. Opportunities: Strong dollar
A stronger US dollar (weaker sterling) can be exploited in funds like M&G Global Macro Bond. This fund can make money from either bonds or currencies or both. Currently it is primarily positioned to benefit from a stronger dollar, and this has worked for a year or so, and there should be more to come.

8. Opportunities: UK small caps and “Value”
In a Trump world where global trade is subdued the UK authorities will have to do EVEN MORE for the domestic economy than Brexit alone requires. This implies two domestic opportunities:

  • UK smaller companies. Funds targeting smaller companies give investors the opportunity to access dynamic long term growth stories. Smaller companies, unlike their slower, larger counterparts, are more nimble and better able to respond to changes, such as the Brexit vote or President Trump. The Liontrust Smaller Companies fund is attractive because of its relatively high allocation to small, dynamic tech and biotech companies: the leaders of the future. You don’t find the next Apple or Microsoft by investing in Apple and Microsoft.
  • Value investing. Buying companies that are unjustifiably cheap (Value investing) has a great record of outperformance over the long term. But Value investing as a strategy has underperformed Growth investing (buying large, established companies that provide steady growth) over the last 10 years. A turnaround is coming and we’re already seeing a move away from large growth companies, so-called “bond proxies”. Buy Schroder Recovery.

9. Emerging markets? They will be hurt by a US which is more protectionist – but not all. The reform-minded economies (e.g. India and Indonesia) will continue to drive forward. Buy Newton Global Emerging Markets – focused on more internally driven stocks, industries and countries rather than exporters.

10. Asia? It is a similar story for Asia as a whole – we need to keep a close eye on which funds have adjusted to the new reality of a world that will be de-globalising at the margin.

For example, Asia will have 10 times more middle class citizens than the US, and five times more than Europe, less than 20 years from now. That is an extraordinary global rebalancing! These factors will drive the profits and dividends of carefully selected companies for decades to come.

As was the case post-Brexit, continue to focus on longer term positive trends around the globe – where there is outstanding value, where middle classes are emerging, where there is reform and young populations, and where there is reliable income.

In particular, UK-based investors must continue to seek out global opportunities, while also being careful to sidestep the negative consequences of anti-Establishment waves in the West.

P.S.  for those who remain inconsolable, remember this:

  • Ronald Reagan was definitely the riskier bet in 1980, he raised tariffs right away and oversaw a deep recession and initial 20% fall in the market – which then tripled in the following 6 years!
  • Richard Nixon was, as we now know, paranoid, angry, a liar, and a racist – yet he managed major accomplishments, even though it is Watergate for which he is most remembered.
Dennehy Wealth