Investment Strategy: Next 6 Months are Key for Trump Presidency

3 September 2017

Welcome to the launch of what will be a regular strategy review.  Macro-themes have dominated market moves, especially following the Brexit referendum and the US and French elections.  With the Trump Presidency entering a potentially decisive six months, I believe this will remain true during the year ahead. I am a believer that identifying just a handful of good ideas is enough to result in portfolio out-performance.  Based on the following analysis, here are a few:

  • Europe equities will outperform the US market
  • The USD’s decline will be reversed — approaching $/Euro 1.12
  • Policy risks shift from Europe to the USA.  Volatility will rise – Buy the VIX
  • US small caps outperform the market, as do financials, health care, and industrials.
  • UK Sterling heads towards parity versus the Euro
  • Mexican peso will rebound, despite NAFTA noise
  • Stocks outperform bonds world-wide
  • Big interest rate cuts in Brazil and Russia. Mexican rates will soon peak, and will be lower a year ahead.
  • BRL, ZAR, and TRY are still likely to decline. PLN and HUF to appreciate.

The Trump Presidency — The Next 6 Months are Vital

No President would ever want to be considered inconsequential.  However, despite all the bluster and Tweets, the Trump presidency has yet to register any substantive legislative accomplishments. Attention will shift soon to the 2018 Congressional elections.  To be sure, the electoral numbers will make it difficult for the Democrats to gain control of Congress, e.g. even in the Senate, Republicans will be defending only 8 of the 33 Senate seats on the ballot.  However, President Trump and Republican leaders will need to record meaningful legislative victories during the next six months in order to ensure a favourable outcome.

Recently, many commentators have speculated that as financial markets no longer expect any major legislative accomplishments in the period ahead, failure will not be a market-moving event. To be sure, the Trump rally has been fading. The prospect of a pro-growth, deregulatory agenda combined with large-scale infrastructure spending contributed to a 15% surge in the S&P500 since Election Day.  Likewise, the initial pro-growth optimism produced a 5% appreciation of the US dollar and an 80bp rise in bond yields. As the early hopefulness faded, however, the stock market has stuttered (the US index has advanced only 2.5% since February 2017), and the USD has declined nearly 10% and bond yields have fallen 40bp.

In addition, reflecting changing perceptions of the Trump Presidency, a dramatic sector rotation has occurred within the US equity market.  As a prime potential beneficiary of the promised corporate tax reform, small-cap stocks outperformed the overall market by 7% in the three months after the election.  Subsequently, these share prices have actually fallen – highlighting the narrowness of the continued rally in other indices.  Immediately after the election, likewise, industrials, cyclicals, and financials outperformed (beneficiaries of strong GDP, higher interest rates, and lower taxes). Technology stocks (beneficiaries of globalisation), utilities/telco (negatively impacted by higher bond yields), and health care (worries about pharma pricing, etc.) all underperformed.  These trends have all reversed as the Trump presidency has lost its early momentum. Similarly, emerging market equities have rallied 15% in recent months, as the likelihood of trade protectionism diminished, at least temporarily.

Unlike the consensus, however, I believe financial markets are vulnerable if President Trump proves unable to implement his electoral pledges.  I estimate that the S&P500’s 15% post-election advance can be attributed roughly equally between higher corporate earnings and a higher market P/E.  In other words, the ongoing strength of the US economy and corporate profits have accounted for just over 50% of the market’s gain.  And, despite the President’s boasts to the contrary, his Administration has had no impact on the solid post-election economic performance.  For example, non-farm payroll gains have averaged 180,000 per month since polling day – the same pace of the past 5 years.  On the other hand, the expansion in the P/E ratio does point to lingering optimism that the Trump agenda will improve the economy’s long term performance.  If he fails to deliver, therefore, I would expect the P/E will revert back to pre-election levels, and the S&P will decline at least towards 2250 (16x 2018 earnings).

What should we expect in the months ahead? Probably more of the same.  Despite recent senior personnel changes, the atmospherics at the White House are likely to remain unaltered – a leopard does not change its spots, especially at 70!  President Trump’s tax reform strategy appears to shift to  Congress the responsibility for developing a plan. Even though the US Senate could adopt a program with just 50 votes (and the Republicans currently have 52 Senate members), the attempts to repeal Obamacare highlight how difficult even this might be.  Passing legislation using the “reconciliation” strategy requires that the overall plan not add to the Federal budget deficit.  In order to achieve the desired large tax cuts, therefore, revenues would need to be raised by either curtailing popular tax deductions or cutting government spending. Given the divisions within the Republican Party, finding a compromise may prove difficult: moderates may object to large-scale spending cuts, while conservative members might balk at any rollback in popular deductions.

Alternatively, any plan adding to the budget deficit would need 60 Senate votes; thereby, requiring support from moderate Democrats.  Given President Trump’s unpopularity in opinion polls, however, the Democrats are not likely to hand the President a legislative victory cheaply. Past partisan clashes and Congressional stalemate warrant scepticism about cooperation. However, Congress will need to shape the tax reform agenda, especially with the Executive branch in disarray.

I expect a relatively modest reform package to emerge from this legislative morass.  For example, the corporate tax rate is likely to decline to 20% to 25%, which is not meaningfully lower than the effective rate firms currently pay.  This will be paid for by a modest scale back in deductions.  As the border adjustment tax has been scrapped, the overall package is likely to add modestly to the overall deficit.  I do expect a large-scale amnesty on the repatriation of corporate profits held abroad, most of which will either  be returned to shareholders or deployed in M&A.  Such a plan will have only a modest immediate impact on corporate profits and investment.  The benefits of lower marginal corporate tax rates, which could be meaningful, will occur over the medium term.

As even this modest tax reform likely will require a few months to craft, and with the Administration still searching for a legislative victory, I expect President Trump to ratchet up the “unfair” trade rhetoric. Again, while this may appeal to his political base, it does not sit well with most members of Congress, especially Republicans. Some of Donald Trump’s supporters (e.g. Steve Bannon) like to frame this as a battle between elite “Globalists” and the President’s “Nationalist/Populist” base.

However, understanding that this is a false choice is important in predicting the markets’ reaction to populist policies.  To be sure, the earlier lack of political backlash to the financial crisis and the rise in income inequality during the past several decades has long been surprising. The causes of low productivity, stagnant incomes, and rising inequality are complex, but trade protectionism and ill-considered financial sector deregulation are not the remedy – a point both Janet Yellen and Mario Draghi made at Jackson Hole. I expect increased pressure on both China (warranted) and NAFTA (not) will increase market volatility in coming months.  President Trump’s base and financial markets would benefit much more from concerted efforts to raise workers’ productivity through funding of education, training, apprenticeships, and infrastructure. (See my blogs at www.brianvmullaney.com for discussions of trade issues, NAFTA, the G20, and China).

Top Investment Themes
#1 Equities will Enjoy Modest Gains, Outperform Bonds:
  • Despite the already impressive length of the current economic cycle, the global expansion remains solid, appears to be gaining near term momentum, and has become more synchronised world-wide. GDP gains have accelerated in nearly all regions: During Q2 2017, EU GDP advanced 2.2% compared to 1.6% a year ago, Japan expanded 2% double last year’s rate. And, while the USA’s 2.1% trailed expectations, the result exceeded last year’s 1.2% pace. The US economy appears  set to accelerate in H2. 2017.  Likewise, key Emerging Market economies are doing better.  Despite earlier concerns, China’s 6.9% Q2 GDP result was stronger than a year ago. And, both Russia and Brazil both have emerged from deep recessions.
  • G3 inflation remains low, and has surprised on the downside. Meaningful price pressures will not emerge until wage growth picks up. And, despite tightening global labour markets, world-wide compensation gains remain modest, and show no sign of acceleration. For example, pay gains of 1.4% in the EU, USA 2.3%, Japan, 0.2%, and UK 2.1% where all more modest than a year ago, despite lower unemployment in all areas. Policymakers are at a loss to explain this trend (Chart 1).
  • With wage and price inflation below expectations, monetary policy normalisation will proceed slowly and cautiously, and liquidity conditions will remain favourable. To be sure, the US Federal Reserve is likely to hike rates in December and begin reducing its balance sheet in September. However, with inflation lower than expected and wage pressures modest, Ms Yellen’s Fed will have reason to proceed cautiously.  Should Gary Cohn become the next Fed Chairman, I would anticipate a pro-growth bias.  Given ongoing wage and inflation trends, the ECB will maintain their plan to only modestly taper QE in early 2018, and to proceed cautiously thereafter.  Even the Bank of England is likely to delay rate hikes until next Spring or later.
  • As a result, I anticipate equities to advance modestly in the period ahead. As an example, the S&P 500 target is 2550 (17 X 2018 EPS) – a modest 4% gain.

#2  Sector Allocations: Back to Small Caps
  • US Small cap stocks have lagged since February. This underperformance intensified in July, as the failure to repeal the Affordable Care Act signalled President Trump’s agenda was collapsing (see Chart 2).  Small caps are both more domestically focused and more likely to benefit from tax reforms than larger firms.  As both corporate tax reform and trade protectionism will be dominant political themes in coming months, I expect the Russell 2000 to outperform the S&P500. 
  • Regarding sectors: overweight financials, industrials, health care, and technology. Underweight Utilities, telecoms, and consumer staples and discretionary. I see no catalyst for the energy sector, as oil prices are more likely to fall than rise.

#3 US Policy Mix Favours the Dollar and Stocks Over Bonds
  • I join the consensus favouring stocks over bonds in G3 markets. While equities are approaching fair value, stocks remain cheap versus bonds – I am likely to make this claim until US 10-year yields reach 3.5%, which is unlikely in the coming year – I target 2.7% in the next year.  Cautious BOJ and ECB policy will prevent global bond yields from rising too much (even in the USA), even as the Fed tightens. And, if US fiscal reform efforts stumble, doubts about global growth could re-emerge.
  • The USD has depreciated sharply as the Trump agenda faded, and as it became evident that a weaker dollar was part of the Administration’s pro-growth posture. However, US fiscal expansion and tighter Fed policy favours a modest USD recovery during the next six months towards $/Euro1.11 and Yen/$120.
#4 Policy Risk Shifts to USA and Lead to Higher Volatility: Buy the VIX
  • As this economic/market cycle lengths, one is aware that bear markets result normally from policy mistakes. And, while European political risk has been the focus this year, attention will shift to the USA. First of all, meaningful moves toward protectionism would be most worrisome. After some bluster, I expect NAFTA negotiations will succeed. China will be more problematic. The US market has not experienced a 10% decline in two years, which is unusual.  I would expect a 5-10% retracement at some point in the next 12 months.
  • I fear the market may be too complacent about the impact about the Fed’s balance sheet deleveraging. At the outset of QE, there was considerable debate about its impact on growth, inflation, and interest rates.  As it ends, there has been little discussion about how unwinding this successful monetary experiment will play out. The truth is, we will only know the answer as it occurs, as we have no historic precedent to guide us.  Also, if US fiscal policy becomes overly simulative, this could require the Fed to become more aggressive than anticipated now.
  • Easy monetary conditions world-wide have contributed to the compression of volatility, but this will not last forever. Indeed, markets have remained calm, as the Fed began tightening. However, as the BOJ and ECB also begin to normalise monetary policy – signalling a tightening of GLOBAL liquidity conditions – volatility will return.  I do not anticipate this theme to emerge during next six months, but I could be wrong!
  • European political risk is not over. Keep an eye on French President Macron’s reform progress. He has been experiencing opposition even during his honeymoon period. (Read my blog on why “Europe Needs Macron to Succeed”).
  • Past concerns about China are likely to reappear. Chinese authorities have boosted the economy prior to this autumn’s 19th Communist Party Congress. However, painful corporate deleveraging still lies ahead, posing serious risks to the medium term outlook.  And, I expect Sino-US trade frictions to intensify. (Read my blog “China: Currency Manipulator” for a roadmap toward a better bilateral trade relationship).
#5 Overweight Europe versus the USA: Double-Digit Returns Expected
  • During the post-crisis rally, Europe has underperformed the US by over 30%, but that is set to change. First of all, EU economic growth has accelerated, and the growth differential with the USA has narrowed. Equally importantly, growth surprises in Europe will be greater than elsewhere.
  • Core inflation stands at only 1.2% — well below the ECB’s target. Moreover, with wages advancing a mere 1.4% (the same as a year ago), inflationary pressures should remain at bay.
  • Below-target inflation will keep the ECB on hold well into next year – at most commencing a cautious QE tapering in early 2018. In contrast, the US Fed will be raising rates and reducing its balance sheet.  And, the recent Euro appreciation provides the ECB additional reasons for caution.
  • Most importantly, as Europe’s profit recovery has lagged well behind the USA, there is ample scope to catch up. For example, while US corporate earnings and profit margins exceed the peak level achieved during the last economic cycle, European earnings are nearly 30% below peak levels and profit margins are still 2% lower than 2008. Time to begin narrowing the gap.
  • Relative valuations are also attractive. Europe’s traditional valuation discount relative to the US market is larger than usual: 18% versus the historical average of 12%.  European P/E expansion should narrow this gap. Euro STOXX 600 target 410, up 12%.
#6 Brexit: UK Sterling to Weaken Further
  • During the next six months, sterling could test parity versus the Euro (and $/£1.20), if Brexit negotiations continue to stutter. The October deadline to settle the three preliminary issues (Irish border, divorce payment, and citizens’ rights) is unlikely to be met, especially with the distraction of the German election. This will delay serious discussion of a post-Brexit bilateral trade deal, perhaps until next year. With the Tory Party Conference around the corner, UK political risk is high:  I expect Prime Minster May to struggle on for a while,  but  a  leadership challenge is likely before March 2019, let alone May 2022.
  • The UK economy will continue underperforming the EU, as ongoing consumer retrenchment provides formidable headwinds (see my blogs on Brexit, the UK consumer). The Bank of England will delay rate hikes until March 2018, or later.
#7 Emerging Markets: Trimming Equity Overweight; Good FX and Interest Rate Opportunities
  • Emerging market equities have surged on the heels of a weak USD, falling US bond yields, positive Chinese growth surprises, and diminished US protectionist rhetoric. These supports are likely to fade: as in the next few months, I expect a stronger greenback, tighter Fed policy, tough US trade talk, and renewed focus on Chinese deleveraging after the Party Conference. 
  • While I still recommend an overweight in EM stocks, I have scaled back the position. Medium term, Emerging Markets will recoup much of the 30% underperformance occurring during this bull market. EM stocks remain cheap: currently trading at a 30% P/E discount to world markets compared to the 25% long-term average.  Asia X Japan is especially good value: trading at a 20% discount versus 12% historically.  As in Europe, the recovery of EM profitability has lagged considerably that of the USA.  EM corporate earnings are still 25% below the peak of the last cycle – the expected 15% EPS NTM gain will begin narrowing this gap.
  • Japan is also overweight. The TOPIX trades at a 27% P/CF discount to world markets (20% historically). Earnings are forecast to rise 15% NTM, and the BOJ remains conditioned to easy monetary conditions until inflation moves higher sustainably.

  • I especially like the Mexican peso (see my blog for full discussion). The inflation-adjusted MXN is at Tequila crisis levels – far too cheap unless NAFTA collapses (Chart 3). Likewise, the Chinese Yuan is expected to appreciate, especially to help defuse trade tensions with the USA.  PLN/Euro and HUF/Euro will benefit from strong economic growth, despite political concerns.  On the other hand, I expect BRL, ZAR, and TRY to resume past depreciations.  Brazil and South Africa will pursue pro-growth policies to offset political risks. Turkish inflation will remain well above target. The Russian rouble will remain a victim of low oil prices.
  • Attractive interest rate opportunities exist in Brazil, Mexico, and Russia. In Brazil, low inflation, weak recovery, and elections point to much low rates, especially as fiscal policy cannot help. Russian inflation will fall well below target (see my blog “Living with Lower Oil”).  As Mexican inflation peaks, The Bank of Mexico will reverse its earlier tightening to support the economic recovery.