The Intelligence Report

06 Feb 2017


T+17. Seventeen days since President Donald Trump’s inauguration, and nearly three months since his election, and the outlook for investors is at the same time more clear and less certain. It is more clear insofar as President Trump has already begun implementing measures that address his campaign themes — trade, immigration, deregulation, infrastructure spending, and corporate tax reform — instead of turning his attention to perhaps less contentious topics. It is less certain as far as the ultimate form these initiatives will take. The recent executive order on immigration, which is currently working its way through the legal process, will only last for 90 days and could be extended in modified form. The impact of the executive order on reduction of financial sector regulation is limited and it will require Congress to meaningfully change the landscape. The administration’s trade concerns have now widened beyond China’s currency to include the euro.

This uncertainty, and the realisation that implementing campaign promises is likely to take longer than expected and may not achieve the desired aims, can be seen in the market’s reaction. Following the initial surge in equity markets, the dollar and bond yields in the month after the surprise election results, Treasury yields have moved down from 2.6% to a range of 2.4%-2.5%. US equity markets have been mostly flat and small cap stocks have in fact underperformed large cap stocks. Half of the initial rally in the dollar has reversed.

These diverse reactions reflect both the promise and the peril of the proposals of President Trump and the Republicans. Increased trade restrictions, attempts to influence the value of the dollar, and significant fiscal stimulus may well have impacts that are negative for US growth and/or inflationary. On the other hand, a stronger dollar, decreased regulation, repatriation of offshore corporate profits, modest fiscal stimulus and inflation, would likely benefit small capitalisation US stocks relative to large capitalisation stocks. Indeed, our multi-asset team is overweight the small cap part of the market.

In this issue of The Intelligence Report, we discuss both sides of the Trump coin, explaining several of the contradictions and risks in the president’s plans in the first article by Steven Friedman, then in the second article by Eric McLaughlin turning to the opportunities for small cap stock outperformance.

The tensions within Trumponomics

Donald Trump swept into office riding a pledge to bring manufacturing jobs back to the United States through a combination of lower corporate taxes, deregulation and better trade deals that would put US companies on an even playing field with the international competition. In the world view of President Trump and his economic advisors, these policies will place the US economy on a permanently higher annual GDP growth trajectory in the neighbourhood of 3% to 4% – about double its current cruising speed.

Unfortunately, there are a number of tensions at the heart of the administration’s agenda that are becoming increasingly apparent to investors, and which in our view make it unlikely that the economy can sustain much higher levels of growth. These tensions may ultimately have the greatest consequence for foreign exchange markets and the Federal Reserve (Fed). In addition, the imposition of import tariffs – and likely retaliation by America’s major trading partners – remains a significant risk.

Fiscal vs. trade policy

One of the main tensions stems from the interaction between fiscal and trade policy. Fiscal stimulus will only worsen the trade deficit through its effects on consumption and the exchange rate. And despite Speaker Ryan’s emphasis on deficit-neutral tax reform, we see fiscal policy as being certain to turn stimulative in the years ahead. This is because Republicans have tied their future prospects to the president and his political base, making it very difficult for them to push back on President Trump’s policy priorities. Signs of this can be seen in Congressional Republicans’ sudden willingness to spend money on a border wall that could cost well in excess of USD 10 billion, when before the election most of these same people viewed the wall as a poor use of funds.

At the same time, it is clear that fiscal prudence is not a priority for Trump. Instead, he favours higher spending on the military and on infrastructure, along with significant tax cuts for households and corporations, while not specifying any meaningful spending reductions. Although to be fair, he and his advisors fundamentally believe that their economic policies will boost growth sufficiently to prevent any widening of the deficit, even after reducing tax rates.

Deficit neutral only under heroic assumptions

The Republican leadership will doubtless push back on the administration in private and may succeed in passing tax reform that is less stimulative than Trump has proposed. And if the border adjustment provision gains support from the administration and Senate Republicans, it would provide a much-needed source of revenue to fund a portion of the proposed tax cuts. Yet by all appearances, the Ryan plan is only deficit neutral under what most economists believe to be heroic assumptions about growth and interest rates. Thus, even if the Republican leadership imposes some restraint on fiscal policy, the stimulative thrust of policy is clear.

As stimulus ramps up, some of the boost to consumption will likely leak out to imports and worsen the trade deficit, an outcome at odds with the administration’s trade policy. In addition, the higher interest rates resulting from additional Treasury issuance and tighter monetary policy will lead to the appreciation of the trade-weighted dollar, even before considering the significant exchange rate impact of the border adjustment provision. In fact, the dollar will likely strengthen well before fiscal stimulus takes effect as investors price in this eventuality. This would serve as a nearterm drag on growth, and ironically, it would be the manufacturing sector and Trump’s political base that would bear the heaviest consequences.

Tariffs this year?

The likely macroeconomic consequences of these policies increase the prospect that the Trump administration will resort to more direct measures to influence trade. The president is likely to grow impatient as tax reform and new spending priorities make their way through Congress, and as he seeks to make good on his campaign pledge to bring jobs home. Meanwhile, he has surrounded himself with policy advisors who share his view that tariffs are a near-costless way of resuscitating manufacturing employment, or at least achieving more favourable trade terms. Furthermore, over the decades, Congress has delegated away significant authority to the executive branch over tariffs, providing the president with a range of protectionist options. Putting these factors together, there is a meaningful chance that the administration will move forward with tariffs at some point this year, which is very likely to spark retaliation from trade partners and lead to a significant deterioration of risk sentiment in global markets.

Even if tariffs are kept on the back burner for the time being, it still does not guarantee positive policy outcomes. Trump and his appointees have already criticised the exchange rate policies of major trade partners, and Treasury nominee Mnuchin commented in his Congressional hearing that dollar strength may have “some negative impacts on our ability to trade.” If expectations for fiscal stimulus or monetary policy tightening serve as a catalyst for dollar strength, these types of communications will only become more frequent and emphatic. Tensions could escalate to the point of foreign exchange intervention to weaken the dollar. This is certainly not our base case, but the stated policy preferences and market views of the administration mean we need to consider this and other scenarios once thought to be so far out on the tail of risk distribution as not to warrant serious thought.

Unenviable choices for the Fed

Finally, with the exchange rate as a flash point, the Fed will not be able to remain outside the political fray. If trade and currency tensions escalate to the point of intervention, the Fed will find itself in the uncomfortable position of having to decide whether to participate alongside the Treasury, using its considerable balance sheet capacity to fund that policy. Even before the situation gets to this point, Chair Yellen or her successor will face considerable pressure to refrain from policy tightening in support of the administration’s trade agenda. The choices for the Fed are unenviable – bow to political pressure and risk a considerable inflation overshoot, or continue to tighten policy and risk more immediate constraints on independence.

The outlook for US small cap markets

Since the US presidential election, which saw Donald Trump win and the Republican Party maintain control of both houses of Congress, the outlook for US equities has changed dramatically. In the intervening months, our view on the possible implications of the election outcome has evolved. As investors, we are always in a position of making decisions with less-than-perfect information. In that context, we have determined what we believe to be the most likely policy agenda to emerge out of Washington and what central scenario appears to be priced into markets – and thus where opportunities may lie if markets are incorrect.

We believe 2017 will be a year of transition. In the wake of the credit crisis, the US has seen a slow, gradual recovery. The US Equities team expects a shift from low secular GDP growth to possibly higher growth and inflation. Stocks have been buoyed by easy monetary policy leading to historically low interest rates. The Fed is now raising rates.There remains a broad sense that President Trump and the Republican Congress will focus on pro-growth initiatives. US equities have rallied in anticipation, but details of these initiatives are still lacking, which makes handicapping what actually might happen extremely challenging. Investors are looking for specifics about tax reform policies, the future of the healthcare system, and how spending priorities will be sequenced.

In our judgement, a pro-growth package would include:

  • A reduction in the top corporate tax rate to 20%;
  • A significant decrease in corporate regulation;
  • Repatriation of off-shore corporate profits at a permanently lower tax rate (i.e. not just a temporary tax holiday);
  • A significant infrastructure programme, possibly funded by the initial burst of corporate revenues brought home under the repatriation plan;
  • Lower individual income-tax rates;
  • Deficit spending.

What might the Republican agenda mean for US small cap investors?

Right now, investors seem bullish about the Trump era. And really, that shouldn’t be so surprising, given that many of Trump’s top economic priorities are also long-standing business favourites: deregulation and tax cuts. Add to this the president’s recent executive orders to advance two pipeline projects and his broader plan to fix infrastructure and you can understand why investors might be optimistic about the future.

All the pieces are in place for a stimulative, business-friendly agenda designed to boost corporate profits. And remember, that’s really what stock investors care about the most. We know that earnings drive stock prices. Not the health of the economy as a whole, but the growth and future profitability of businesses. The consensus view is that the Trump administration should open lots of new opportunities for profit.

Of course, there is also a high degree of uncertainty. President Trump’s continuing commitment to erect new trade barriers, his willingness to bully companies, and potential conflicts of interest with his own businesses could have big economic consequences.

Smaller companies could benefit the most…

We’ve found smaller companies benefiting from rising risk appetite. Furthermore, small capitalisation companies (small caps) tend to have greater operating leverage due to weaker economies of scale.

We expect that merger and acquisition (M&A) activity will continue to be an important theme in assessing small cap stocks. 2016 proved to be a cycle high for small cap M&A, as reflected in both the deal count and deal value for Russell 2000 stocks. Although fiscal stimulus and/or tax cuts could potentially steer companies away from “buying” growth, we think the opportunity to acquire technology, customers, capabilities or earnings accretion will continue to be a strong motivator.

Given fears over Trump’s trade policies, stocks with high domestic exposure, in particular small cap stocks, are likely to do better than global names. The prospect of a rising dollar favours companies with a greater domestic orientation. In addition, small cap stocks have a stronger correlation than large cap stocks to US GDP growth and if growth rises, small caps would benefit. Our market view is focused on economic sensitivity.

…and more in certain sectors than in others

Industrials (and infrastructure stocks) should profit given their cyclical nature and domestic focus. Financials have rallied post-election due to the expectation that Trump will be less onerous on regulation. In our judgement, higher interest rates should encourage increased bank lending and consumer spending. Income-tax cuts could help boost household spending in the future and that may propel consumer stocks. As for the technology sector, it is our expectation that it could get a push from the repatriation of corporate cash holdings driving more M&A in this sector. Companies can also use cash to buy back stock and pay dividends, which can help performance.

Over the last year, healthcare has been the worst-performing sector in the US equities market due to political uncertainty relating to drug pricing, a temporary slowdown in drug approvals and the potential repeal of Obamacare. This underperformance has brought the sector’s relative valuations to historically compelling levels. It may take a few months for the policy outlook to become clearer, but we believe the ultimate policy landscape will improve. We see the most significant opportunities in biotechnology stocks as we believe drug-pricing concerns are overblown and innovation remains strong.

Finally, we see a return of idiosyncratic factors driving stocks, which tend to lead to a broader dispersion of returns and thus can be a more favourable environment for stock-picking. Market leadership is becoming more dynamic, suggesting that investment selectivity is growing in importance, an implicit argument for active management.

In closing, the recent rally in US small cap stocks has made them more expensive compared to their historical average, but they are still cheap relative to large caps. In our judgement, earnings growth will justify the higher prices.

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