In the run up to the election, there was a universal fear of the politically unknown, firebrand, former reality TV star and his more controversial threats to dismantle global trade agreements and deport illegal immigrants. However, Trump’s acceptance speech in the immediate aftermath of election night struck a conciliatory tone, and has since caused a re-appraisal of the prospects for bonds, stocks and inflation – at least for the time being until more details of his campaign policy proposals emerge.
Let us start by stressing that the policy priorities of the new administration are mostly a basket of known unknowns (to paraphrase Donald Rumsfeld). We know that anti-free trade rhetoric is part of the agenda, yet we do not know how much resistance this could meet and we know that scrapping Obamacare, de-regulating the financial sector and a general move towards ‘smaller government’ are very close to most Republican hearts. But these are all probably easier to champion on the campaign soap box than from a chair in the Oval Office. However, there are two areas of policy where Mr. Trump could deliver on his promise of change without ruffling too many feathers. These are tax reform and infrastructure spending. It is the prospect of change in either or both of these policy areas, which are undoubtedly reflationary, that has led to one of the fastest and sharpest percentage rises in bond yields on record, as markets begin to discount larger deficits, faster growth and higher inflation. It is far too early to call definitively, but we may look back on July 2016 as having marked the all-time low in US Government bond yields.
Trump’s tax proposals are easily the most audacious since Reagan’s in the early 1980s. The scope ranges from cutting the highest marginal rates of personal income and capital gains tax and eliminating federal inheritance tax altogether, to slashing corporation tax and allowing a “tax holiday” for US companies to repatriate up to an estimated US $2.5tn in foreign earnings currently sheltering offshore.
From an investor’s perspective, a lowering of the statutory rate of corporation tax carries perhaps the greatest potential impact of any of Trump’s policy proposals given it directly affects earnings. Corporate profits have faced all manner of headwinds in the last few years: from financial sector spending on regulatory compliance and balance sheet repair, to resource and manufacturing sector weakness as global commodity markets have collapsed, to general headwinds from a strong US Dollar. As we start to see these headwinds diminish, corporate earnings could pick up.
At the same time, the impact of the Federal corporate tax rate falling from 35% to the UK rate of 20% would yield a 23% boost to net income for American companies paying a full tax rate. If Trump gets his way with his proposed 15% tax rate, the boost to net income is worth 31% for companies currently paying the full rate.
Repatriation of foreign earnings is also something that has garnered attention (and bi-partisan support), and it is at the centre of Mr. Trump’s other pro-growth policy initiative, which is infrastructure spending. The thought process is that the tax take from any repatriation of foreign earnings by US corporations will partly fund a US $550bn Federal infrastructure investment package in airports, schools, hospitals and so on. With the average age of the US’s fixed assets at the oldest level since data began in 1925, there is universal agreement that something needs to be done (and having experienced Manhattan roads and traffic last week, I concur!).
We are a little more sceptical of the immediate stimulative capacity of infrastructure spending given any proposal could take some time to become law, and further time to implement. We also feel certain industrial areas of the market have rapidly priced in these prospects, leaving little cushion if the size of any infrastructure stimulus package disappoints.
Set against these two positives is the large unknown of the President- elect’s trade policy. The erection of barriers to the free mobility of capital and labour will act as a drag on global economic growth. We have very little clarity on how aggressive Trump’s trade policies will be, but we do think he is a pragmatist, and he knows there are an estimated 11.5 million US jobs in some way linked to export industries (40% of which are services). He will need to tread carefully.
As we reflect on what all of the above means for US companies, we are reminded of the notion that universal healthcare provision, tax cuts, infrastructure spending and a balanced fiscal budget are incompatible bedfellows. There are parallels with Reagan, but this is not the 1980s. Stock markets are at highs not lows – the US market capitalisation is 196% of GDP today versus 40% when Reagan took office. Reagan also had a falling interest rate environment to work with (not a rising one) and a huge demographic tailwind from Baby Boomers coming of age. Nevertheless, we think the prospects for potentially better growth, lower corporate taxes and a further pick up in subdued inflationary expectations outweigh the potential negatives for US equities.
We have remained cautiously optimistic in our outlook for US companies throughout 2016, even earlier in the year when others feared a recession. Our underlying stock selection has reflected our perception that we will realise greater long-term value creation potential further down the valuation curve, where the market is not already discounting high returns and where we feel we can bene t from both a fundamental and valuation margin of safety.
We have also felt that companies with less leveraged balance sheets have been a source of hidden opportunity in recent years. The sharp move higher in debt service costs since the summer has vindicated this stance and we believe a bias towards low leverage will continue to yield rewards. As a generalisation, the above thinking has led to overweights in areas such as cash-generative technology companies, healthcare services stocks (as opposed to pharmaceuticals) and financials, where valuations tend to be below market medians, and where fundamentals of the stocks in the portfolio are better than average.
We believe, on balance, that President Trump will foster a reflationary and potentially pro-growth agenda. However, we also think the key will be to remain focused on fundamentals and highly selective at the stock level.