Ed. note: The following commentary was written prior to Donald Trump’s inauguration.
US equity investors have focused more on hope than fear since Donald Trump’s election. Ironically, many commentators believe his campaign rhetoric focused more on fear than hope. In 2017, we expect the stock market will be animated by competing views of whether economic policies and actions of President Trump and a Republican Congress instill hope or fear. The Trump victory increased risk (downside and upside), with fatter tails on policies and markets. During the campaign, Mr. Trump promised many things, some very bullish for company earnings, from tax cuts and infrastructure spending, and some very bearish, from tariffs to immigration restrictions. It is unclear what of these initiatives and plausible outcomes will play out in 2017 (we wrote extensively on the topic of what might happen, just post election, see footnote 1 below). In its first two years, the Obama Administration was only able to affect two signature pieces of legislature, on finance and health, aside from fiscal stimulus. Depending on President Trump’s focus, the US economy could speed or slow down badly. Then there’s getting to consensus in Washington – there’s what Trump says, what he wants to accomplish and what he can manage to get done.
The inauguration occurs on January 20th and many political and market pundits believe much legislation will be proposed during the first 100 days. The prospect of lower corporate taxes, repatriation of overseas cash, reduced regulations, and fiscal stimulus has already led investors to expect positive EPS revisions among US public companies. Near term positioning has and continuesto be 1) Cyclicals over Defensives; 2) Stocks with high US versus foreign sales exposure; and 3) High US tax rate paying companies. “Hope” in 1H17 suggests US equities, “Fear”, possibly in 2H17 might suggest favoring Europe (with some things going right there in 1Q17 politically).
Macro and Market Volatility Rises
We see a wider range of possible outcomes in 2017. We should also accept that we will likely see regular flip-flops on policies and politics. As discussed herein, this means shortening one’s investment horizon, staying liquid, and being ready to trade on extreme moves. In markets, there is what can go right and what might not, as a consequence of possible sea change in Washington policies and procedure. What can go right: US fiscal stimulus boosts growth just as EPS growth accelerates, leading to new highs in equity markets. Animal spirits, in both corporate and investors, return in a way they haven’t so far in this cycle. Higher yields turn out to be less of a drag than assumed, at least for the time being. What could be not so good: Higher growth and inflation could lead to a more hawkish central bank response than expected. Corporate leverage is unusually high for this point in a cycle expansion. Risk premiums, while not extreme, are hardly ‘cheap’ across asset classes.
Our macro outlook now factors in a higher likelihood of boom or bust (and less of “lower for longer”). We think both offense and defense are better expressed by owning options, given this market backdrop, trading to harness what might appear to be unsustainable gains, looking for future entry points. We had previously been inclined to sell spikes in volatility, but now prefer to be a buyer of volatility dips.
Given the run up in markets post-election, we will think about allocation of capital in shorter time increments, waiting to see,say, what 1Q17 brings in the US and 1H17 in the US and Europe.
Favoring US Domestic-Centric Company (whether US Company or Non-US Selling in US$) Equities
An America Firstpolicy could easily invite other countries to follow suit, depriving the world of a natural leader and policy coordination on issues that affect all countries, such as trade and the environment. Here also, we need to see what campaign slogans survive the reality of actual decision making. Globalization was already in retreat before the Presidential election in the US. To investors, this means increased geopolitical and market risks, but also greater opportunities to add value through country selection and drilling down further, to companies (and their potential catalysts) benefiting or hurt by a strong US$ or sourcing goods overseas.
The rally in Developed Market (“DM”) equities and the US Dollar are still modestly underperforming our perception of earnings growth and relative US performance. Global and US equities are at new highs, but have barely moved out of their recent ranges. Even without a stronger US or global economy, the expected cut in US corporate tax rates should boost US after-tax corporate earnings.
“Smaller” Caps – Off the Radar, and Greatest Beneficiaries of US-Centric Fiscal/Tax Policies to Be
For the first time in years, I may see the logic in small-caps versus large-caps in the US! First off, smaller US public companies are more likely to provide the most fertile ground for us to find event-driven trade prospects from a screen of companies that derive all or mostly all revenues domestically and would therefore, be larger beneficiaries of favorable, prospective corporate tax rates. Additionally, reduced individual tax rates coupled with reasonably decent US economic data and plausible fiscal policy stimulating capital expenditures in the US can drive revenues for such companies. Finally, among event-driven managers, smaller-cap companies are a great place to differentiate from the largest event-driven hedge funds, that can really only participate in large caps given the scale of capital they put to work. Large caps therefore, may be crowded, affording the upside of looking like everyone else and the downside of carnage when everyone’s a seller at once.2
The US Dollar’s relative strength, tax reform, and potentially draconian trade policies: all of these directionally favor US small -caps. We had been in the large cap camp for much of the last two years on a belief that they offered above-average estimate achievability, but that now seems less realistic as overall market earnings seem likely to rise.
Intellectual Preference for Cyclicals over Defensives But Valuation at Issue
Cyclical outperformance will continue in the near term, fueled by expectations of faster GDP growth, higher interest rates, and rising inflation. Declining bond yields and fears of a stagnating global economy powered the out performance of defensive, bond-like industries for much of the last three years. The rise in inflation expectations and interest rates during 3Q16 drove investors away from firms with high dividend yields and perceived safety into equities with higher sensitivity to economic growth. Following the election, the inflationary nature of President-elect Trump’s fiscal stimulus plans has spurred both bond yields and the Cyclicals vs. Defensives trade higher. A hopeful outlook for Trump policy suggests further upside to this strategy, with the Fed hike in December the earliest and recent catalyst.
US domestic cyclical industries including Banks, Insurance, and Transportation are positioned particularly well to outperform
during the hope-driven rally. These industries carry much lower approximate valuations (14x vs. 19x) than global cyclicals and the median stock has greater revenue exposure to accelerating US economic growth (77% vs. 51%). In addition, many Financials will receive an earnings boost from higher rates. Nimbleness, Revenue Growersand Plausible Catalystshelp support our view of further froth here, as frankly, Cyclicals are not so inexpensive anymore, trading at the same approximate P/E multiples as Defensives, despite historical valuations about 10% lower.
US over Europe in 1Q17 but Who Knows in 2Q17, Plausible We Flip This
“Fear” may pervade during 2H17. If, as some economists suggest, inflation will reach the Fed’s 2% target, labor costs will be accelerating at an even faster pace, and policy rates could be 100 bp higher than today. Rising inflation and bond yields typically lead to a falling P/E multiple. Congressional deficit hawks may constrain Mr. Trump’s tax reform plans and the EPS boost investors expect may not materialize. Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in 2H17. The median stock trades at the 98th percentile of historical valuation based on an array of metrics. If we get “Fear” in 2H17, we’ll prefer Low versus High labor cost companies in the US (with concomitant longs and shorts); and 2) Strong versus Weak Balance Sheet stocks. We might also favor Europe over the US in DM with certain political outcomes in 1H17.
Many in markets appear to be very nervous with respect to Eurozone politics. Some simply shut down on non-US markets, in part, for lack of effort around understanding, or narrowness of mandate. While we believe that the potential for the Eurozoneto break up on a multi-year, perhaps 5-year horizon, has gone up materially in light of Brexit vote, current investor positioning in Europe seems overly bearish. If, as is likely, Eurozone political uncertainty doesn’t spiral out of control over the next 18 months, then European equities are quite cheap relative to the US.
Eurozone earnings delivery has started to turn up most recently, recording the first positive YoY growth rate in a year. In terms of the big reflation theme, we think Eurozone is well positioned. The region typically benefits from rising yields. Historically, there was a very close link between the direction of US bond yields and the Eurozone/World performance, but we note that there is a break seen most recently. This decoupling is likely due to the uncertainty into the Italian referendum, but we think the gap should start closing.
The Eurozone election calendar is heavy in ’17, with elections in the Netherlands, France and Germany. Political uncertainty is surely at the forefront of global investor concerns with respect to the outlook for Eurozone equities. Peripheral and French spreads have made fresh 3 year highs, which many see as a red flag. However, we believe that some of these concerns might prove to be overdone. The latest polls for the French presidential elections are giving a significant lead to the Republican candidate Francois Fillon over the anti-establishment candidate Marine Le Pen. This is in contrast with the tight polls that preceded the Brexit referendum earlier this year.3
The Italian referendum result, if there is a resolute “No”, could lead to knee-jerk risk off sentiment in Eurozone, but we think that one should use the potential volatility in order to add exposure to the region.
Use this as a Checklist to Determine Enter or Avoid Europe
The Forgotten Discussion of the Cycle (in all the Froth Around a Business-Friendly Washington)
As we enter the 8th year of the current economic expansion, the dynamics of a mature cycle present opportunities and risks regardless of the politics in Washington, D.C. After 8 years of job creation, the US hovers near full employment. Although Mr. Trump’s election has improved the outlook for job growth, even prior to Election Day forecasters including the FOMC expected that the unemployment rate would continue to decline during the next few years. A tight labor market signals the later stages of the economic cycle and is typically associated with rising return dispersion as idiosyncratic growth profiles, margin pressures, and uses of cash differentiate stock performance. While we can make money in this time and place, particularly with an agnostic and dynamic mandate directionally, among securities and among the myriad plausible events that re-price securities to fair value, this expansionary cycle maybe in it’s waning period and that discussion seems to have stopped around Election Day.
I trust you but cut the cards – W.C. Fields
2016, in retrospect, required nimbleness. We expect 2017 to be similar. We think that faith in ‘reflation’ can continue through 1Q17 as optimism in fiscal policy sparks up the dry tinder of already rising global yields, inflation and earnings. We are wary, however, that by 2Q17, the market will confront a more hawkish Fed, a still-strengthening US$ and possibly, renewed moderation in China’s growth. Political reality may also set in, as high expectations for action by the new US administration become hard to meet and market optimism has been front end loaded into the post-election market rally.
With less forward visible runaway ahead of us, give transition in Washington and macro factors in Europe and the rest of the world, we see fatter tails, a wider distribution of outcomes. This suggests owning and wanting to harness the value in the likely foreseeable volatility. The lower-for-longer assumption we previously operated under has been eroded by the political developments on both sides of the Atlantic.
Despite the non status quo nature of the transition of power in Washington, a trend of rising yields, steeper curves and better earnings has been in place for months. It’s feasible that this persists through 1Q17. Still-easy year-over-year comparisons mean headline inflation and global earnings continue to rise. An initial lack of policy clarity from the Trump administration may actually be helpful, in our view, allowing investors to believe that the US ultimately will pursue “good” projects (e.g., infrastructure spending) and avoid “bad” ones (trade protectionism), while dangling the possibility of large corporate tax cuts. Again, however, it is our base case supposition that new Administration initiatives will be slower to come, be more negotiated and not generate the theoretical economic consequences many want to believe to be feasible.
1 See our take on plausible allocation considerations given Trump policy prognostications. Long Trumps Short or the Trump and Dump? The Trump Trades Setting Up for 2017. Shark Bites Vol 6, Article 4 December 2016.
2 Far from the Madding Crowd –Averting Underperformance (and Profiting) from Crowded Hedge Fund Trades. Shark Bites Vol 6 Article 1 April 2016. http://nebula.wsimg.com/900f19380e76894cd68447a4a98fc482?AccessKeyId=ED7655C1814E263BA776&disposition=0&alloworigin=1
3Goldman Sachs Portfolio Strategy Research, November 30, 2016
The above post has been excerpted from a letter of Tiburon Capital Management.