The Intelligence Report

20 Feb 2017

Overview

Financial markets have reacted strongly to Donald Trump’s surprising electoral victory last year. US equity markets have reached new all-time highs, while Treasury yields have reac and curves have steepened bearishly. Credit markets have performed well, particularly US high yield. Within equity markets, there has been a pronounced rotation towards cyclical vs. defensive sectors; energy and banking stocks have outperformed, whereas rate sensitive telcos and utilities have lagged. These market developments also reflect a backdrop of normalising growth and inflation data, rising business confidence and elevated hopes for tax reform, fiscal spending and deregulation. Recently, however, Donald Trump’s tweets and more formal statements indicate that he intends to deliver on his campaign statements, and with apparently little pushback from the congressional Republican party, market momentum has slowed.

As we await Donald Trump’s key congressional address on February 28th for more signs about future policy, Momtchil Pojarliev considers
whether there is a case for a further leg in the dollar’s multi-year rally, or whether the current consolidation phase witnessed this year could yield to a more significant setback. The US earning season is now 81% complete, and companies have, on average, met solid earnings expectations. As ever, the devil is in the details. In the second of our pieces, Daniel Morris reviews corporate results in more detail in order to determine whether these bottom-up earnings signals validate topdown investor optimism, and whether further equity upside from already elevated levels can be expected or not.

US dollar: expensive, but well-supported

The Trade Weighted US Dollar Index has rallied by 25% from the second half of 2014 until the end of 2016 (see Exhibit 1) for three reasons. First, non-US central banks pursued competitive currency devaluation as a tool to fight low inflation. Second, the US Federal Reserve (Fed) started to normalise monetary policy by raising interest rates, turning the US dollar into the third highest-yielding currency within the G10 with interest rates higher only in Australia and New Zealand. Third, after the US elections, market expectations for fiscal policy divergence drove the recent leg of the rally.

After this 25% rally, based on valuation, the US dollar looks expensive, in our view. The Japanese yen is undervalued by 32% versus the US dollar and the Swedish krona is undervalued by 47%, based on purchasing power parity. So the question now is: can this rally continue? It is pretty clear to us that both the Bank of Japan (BoJ) and the European Central Bank (ECB) have moved away from specifically targeting currency weakness and are now more open to allowing their currencies to appreciate. Devaluing the currency does not work when everyone is doing it. Even the Swiss National Bank (SNB) was forced to accept a stronger Swiss franc and abandon the floor of 1.20 against the euro.

This shift by the ECB and BoJ from explicitly keeping their currencies weak to allowing some appreciation is significant as competitive currency devaluation was the main driver of the first leg in the dollar rally. Furthermore, the recent comments by the US administration about foreign countries manipulating their currencies will make it more difficult for them to openly intervene in the currency markets.

So, if the ECB and the BoJ are not driving the euro and the yen lower anymore, will we see US dollar strength caused by the Fed’s policy? This looks more likely now than it did last year, in our view. At the beginning of 2016, the Fed had signalled there would be four rate rises by the end of 2016, but it actually delivered only one. However, the three increases expected by the end of 2017 look more plausible. US economic data continues to be firm and the two most recent speeches by Chair Yellen suggest that the majority of the voting FOMC members still expect three rate rises this year. Finally, the case for fiscal policy divergence remains intact, but we will need to see more details regarding any tax reforms by the new administration to be able to better gauge this factor.

We believe the US dollar is already overvalued and one of the key reasons for its rally is no longer valid as foreign central banks are now open to allowing their currencies to appreciate. However, monetary policy divergence is still in place and there are real prospects of a fiscal policy divergence. To us, the US dollar will remain wellsupported until foreign central banks also start normalising monetary policy.

US earning season: high expectations

Is it good enough? That is, were fourth-quarter earnings by US companies good enough to support a price/earnings multiple on the S&P 500 index that is nearly 25% above the long-run average?

At first glance, the results were generally solid. Profits for the 406 of the 500 companies that have reported so far were up by 7.7%, and forecasts for the full set of S&P 500 companies come out at +7.2% year-on-year. As revenues advanced by just 4.8%, this means US companies managed to increase their margins yet again despite persistent market worries that margins have peaked.

A closer inspection, however, raises concerns about the sustainability of this profit growth. The bulk of the gains, 42%, came from the information technology sector; the failure of Alphabet’s [GOOGL] earnings to match market expectations highlights the risk that IT companies may not be able to continue generating double-digit EPS expansion (see Exhibit 1).

The second key sector was financials and here the earnings landscape has indeed improved thanks to rising interest rates improving margins and the rally in US equities since Donald Trump’s election last November boosting trading revenues. Given the prospect of reduced regulation, earnings could improve yet further. The concern is how much of this has already been priced into the market. Since the US election, the financial sector has gained 27% compared to a 9% advance for the market as a whole. The S&P 500 banks index has powered ahead by 40%. The price-to-book value of the index has risen to 1.3x from a global-financial-crisis (GFC) low of 0.6x. Whether the current price-to-book metric means banking stocks are expensive or cheap depends on whether the future resembles the pre-GFC or post-GFC world. Before the global financial crisis, the average price-to-book multiple for the index was 2.3x, which compared to the current 1.3x would suggest banking stocks are still attractively valued. But the multiple since the GFC has been just 1.2x, suggesting that stocks have become slightly pricey. Though there is still a significant degree of uncertainty about the prospect of regulatory reform, in our view there is still some value in the sector.

Healthcare sector earnings were resilient in the last quarter of the year, in contrast to the 15% underperformance of the sector index relative the S&P 500 for 2016. The future is cloudy, however. The timing of any repeal of the Affordable Care Act is uncertain, let alone the configuration of what might replace it. Expectations of increased competition and pricing pressures have damped pharmaceutical earnings forecasts, but healthcare providers and services companies should still benefit from an expanding and aging population. Maximising profit from the health care sector’s transformation will require identifying the winners and the losers rather than betting on the whole industry.

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