In the November Investor Letter, we characterized the markets psyche in the context of hope and fear. With some in house perspective about our footing through 1H17, we will focus those factors driving “hope”, which can fuel a profitable first half of 2017 for markets. The President-elect takes office on January 20, 2017. While the optimism of markets with the prospect of policies favorable to business seemed a bit front-end loaded from Election Day to date, our work suggests that the Trump administration has an ambitious agenda to drive certain reforms in the first 100 days – or by April 30th. This would require much of the shape of reform to be in the public domain relatively quickly. As we saw with the hope of certain pro-business reforms, the markets can move yet again, on increasing clarity over these next 100 days. Additionally, we will discuss later on, the plausibility and alternative perspective that the recent rally was more about company performance and economy, less about the President-elect.
Tax Reform Drives Share Buybacks – Share Buybacks Drive US Equity Outperformance
Since 2010, buybacks have been the largest source of US equity demand. Goldman Sachs anticipates a 24% jump in buybacks this year given the expectation of corporate tax reform. A tax reform package will most likely include a one-time tax on untaxed foreign profits, which will encourage firms to repatriate overseas cash. We expect firms will direct most of their repatriated cash towards buybacks. Excluding the repatriation boost, gross buybacks will benefit from modest US GDP growth, high cash balances, and the outperformance of firms repurchasing shares. A key downside risk to company share buyback demand, is the potential repeal of net interest deductibility proposed by House Republicans because firms might respond by increasing share issuance to reduce leverage.
Prefer DM over EM, US over Europe through 1Q17
We prefer long US versus EM equities on the prospect of pro-growth policy reforms under new administration (i.e., deregulation, tax reform). That said, the incremental hawkish tone from the FOMC at the December meeting raises the hurdle for both equity multiple expansion and corporate profitability. In particular, we see the US dollar as a significant headwind. Historically, we have seen that a 6% rise in the trade-weighted USD index would pressure the S&P 500 EPS by roughly 2-3%. In a rich valuation environment, these risks are meaningful but they will likely be offset by accelerating global growth. At the same time, EM remains susceptible to further USD strengthening and potential trade disruption by the new administration. Finally, as mentioned in our November Investor Letter, Europe’s economy is in reasonable shape and equity markets vastly cheaper than US. There is a large political calendar with perceived political stability in Europe weighing in the balance. We may feasibly get through the various elections in Europe and see European equities as equally or more attractive than US equities, particularly if the perceived Trump pro-business policies appear watered-down, harder to enact and/or delayed, as we enter 2Q17 or 2H17.
Among US Equities, Prefer High Domestic Sales
US domestically-focused companies, with nearly 100% US sales (vs. 73% for S&P 500) are insulated from FX headwinds and trade policy risks we see in the potential new legislation proposed by the Trump administration. Smaller-cap companies should be preferable to large-caps as smaller will tend toward US domestic-centrism, and will be under-followed but the herding, larger event-driven (and other) investment managers.1
2Q17 or 2H17 Potential Preference for European Equities
The Eurozone is typically a big beneficiary of a rotation into Value. Our concern is the heavy election calendar, but valuations look attractive and sentiment/positioning is already negative. Eurozone equities have lagged significantly in 2016, had big outflows and the region has de-rated. At the same time, the Eurozone business cycle is clearly at a much earlier stage than the US one. It is our view that Eurozone equities are attractive against the backdrop of rising bond yields and rising inflation.
While we believe that, assuming we get through the Eurozone political decisions unscathed, European domestic companies are cheapest on a relative basis and poised for recovery, there is the immediate tailwind for those Eurozone companies that are European issuers (and Euro costs) but predominantly USD revenue generators based on their magnitude of sales in the US. 50% of European Large Caps collect about half of their sales outside the region and small caps a third, often with expenses chiefly in Euros. Europe may be bar-belled in allocation strategy, then, with the best value in smaller domestic-centric companies and in European large caps with significant US exposure. Approximately 50% of European large caps derive more than 50% of revenues in the US and in USD.
1 Global Asset Allocation, JP Morgan Research, January 5, 2017
2 Macro, Sentiment and Market Cycles, Barclays Global Equity Strategy, January 5, 2017
The above post has been excerpted from a letter of Tiburon Capital Management.