Trump trade stalls as market worries over policy delivery

Donald Trump has rarely been off the frontpages ever since his surprise election win on November 9. 

On the one hand there have been the travel bans, the sabre rattling over North Korea, the accusations of wiretapping and rumours of Russian involvement in his win. But on the other there has been the US stockmarket reaching new highs, buoyed by Mr Trump’s pledges to reform taxes, slash regulation and boost infrastructure spending.

But can these new highs last? Will Mr Trump be able to deliver on any of his pledges and are these the correct policies that should be enacted in any case? And with all of this going on, just how should investors be approaching US equities?

Mr Trump and his plans are undoubtedly a big change to conventional wisdom, says Gary Potter, co-head of the F&C Investments multi-manager solutions team. “Trump is going to shake up the economy and politics. He is a businessman, not a politician. He just sees route one.” 

Mr Trump is not the only factor in town, he says, explaining how much of the boost we are seeing in the US economy could be down to the stimulatory effect of lower oil prices 18 months ago now feeding through. 

Nevertheless, it is risky to try and predict what is going to come out of Washington DC, and when it is going to happen, warns Andrew Acheson, head of the US equity growth team at Pioneer Investments. He explains how the Trump victory led to very high expectations, and admits to being surprised by the strength of the so-called ‘hope trade’.

This trend is based on three things, says Mr Acheson. Firstly, the most significant piece of proposed legislation, in his view, is in the area of tax reform, at both the corporate and personal level, where the president has promised to simplify and lower taxes. With the US having the highest levels of corporation tax within the OECD, there is clearly some scope for movement here.

Next in order of importance, according to Mr Acheson, is deregulation. “This is an significant expense for many businesses and regulation clearly has a bigger impact on small and mid-sized businesses who have to spread that cost over a smaller revenue base. Since most new jobs are created by smaller businesses, de-regulation could be very beneficial for the economy.” 

The third part of the hope trade concerns infrastructure spending, though Mr Acheson believes this has been moved down the priority list. “It is a rather odd time in the economic cycle to be doing significant infrastructure spending, given the unemployment rate is around 4.6 per cent, and we are likely late in the economic cycle. It is not like the economy needs a huge boost from infrastructure, although I would agree infrastructure itself is need of significant improvements. It is absolutely subpar for a developed country.”

It is the promise of significant changes to legislation in these areas that helped drive US equity markets to their recent highs as investors picked out sectors of the economy likely to benefit from the changes. For example, the promise of deregulated banks saw financials soar, while small and mid caps rose sharply as it was perceived they would benefit from boosts to the domestic economy.

But will any of this legislation actually come to pass? President Trump has already seen his much-vaunted repeal and replace attack on Obamacare fail to get through Congress. Prior to this setback the worry was dogfighting over healthcare would delay the other important pieces of legislation. Now the worry is the Trump administration will fail to get anything substantial through at all. 

“Repeal and replace was clearly rather more difficult than the Republican Party had imagined,” says Mr Acheson. “And if you thought Obamacare was a difficult thing to repeal and replace, wholesale tax reform will be much harder.”

Financial stocks in particular have done very well since the election. “The perception is that if you ease regulation, the banks will be able to start lending,” says Jonathan Lemco, senior investment strategist at Vanguard. “There is a perception getting rid of red tape will make doing business easier.”

Anyone who examined Mr Trump’s policies and tried to identify which areas would benefit saw banks were the one sector ticking all the boxes, says Geoff Dailey, portfolio manager and senior analyst for US equities at BNP Paribas Investment Partners. 

“Whether its tax policy, deregulation, higher interest rates or economic growth, all favoured financials. And it was also an underloved sector and underowned sector, which for years had been under a lot of pressure from increased expenses, higher capital ratios and so on.” 

All bank stocks moved up sharply following the election, he explains, with small caps doing especially well. But we have now reached a juncture where the market needs to  see execution on some of these policies. 

“Expectations have been raised, valuations have been raised … so far everything has been positive on the deregulation front. He has put the right people in place, at least from a bank stock investor point, but there is a lot left to do.”

Not everything needs to go through Congress though, explains Mr Dailey. “There are some key nominations that can be made which can have significant influence on the banks in terms of reigning in the reporting and so on that they have to do, without requiring Congressional approval.”

But he points to the pullback in industrial stocks because of the perception that a lot of policies would take place immediately, which has not happened. “The market is trying to digest the speed and pace of economic growth and how these policies will progress.”

The market dipped following the failure of repeal and replace, while US equity funds saw outflows as investors worried over what might happen next. But are stocks in line for a larger correction, and just how healthy is the underlying economy? 

Lombard Odier Private Bank is cautiously optimistic on the US economy, but is under no doubt the equity market is towards the top of its historical range in terms of valuation, says head of investments Stéphane Monier. The bank is pro-cyclically positioned with overweights in financials, energy, industrials and consumer discretionary, with its largest underweight consumer staples.

The biggest support for its overweight in financials has been valuation, although this is becoming a weaker argument as some of these names have rerated significantly over the past five months, he says. But the bank believes there is more appetite for financial regulation reform, and the sector therefore remains attractive.

“We have been using recent weakness in the energy sector to add to our positions,” says Mr Monier. “We think longer-term, the oil price should trade higher on the back of OPEC discipline, but also on the back of strengthening demand. The recent pullback is a buying opportunity, and the lack of draw on reserves in the US is a temporary phenomenon.” 

The Republicans are pro-energy and he notes there could be significant stimulus in the future from the issuance of new drilling permits and the relaxation of emission standards.

Mr Monier describes small caps as “the poster child” for Republican fiscal reform as they have far greater exposure to the domestic economy and tend to have higher tax rates than large caps. “In the medium-term, we think they should do well, however, we remain somewhat more cautious near term, as we await further clarity on the timing and details of the reform agenda.” 

Smaller companies were seen as the best expressions of the ‘Trump trade’, but that initial trade is now behind us, believes Adam Schor, director of global equity strategies at Janus Capital Group. But given the current environment of low rates, earnings growth and increasing risk tolerance among investors, US stocks are not overvalued, he claims.

“While it is tough to argue multiples expand sharply from here, we do think companies that can provide sustainable above-average earnings growth will be attractive to equity investors.”

But volatility in the future is to be expected, especially if it appears Mr Trump’s agenda is stalling. “While we still think the more confident corporate environment can persist, the markets may see a volatile period as we watch the legislative process and battles unfold,” adds Mr Schor.

Generally speaking, the US economy is in full swing and robust, believes Christoph Riniker, head of equity strategy research at Julius Baer, and he is not concerned about the macro development for the time being, nor for the stockmarket. “While we only see limited potential there we don’t expect a major setback.”

The Swiss bank is following a slightly cyclical approach. The US labour market is healthy and will be supported by the US government’s shift towards large fiscal stimulus, he explains, adding this will not only lead to an acceleration of GDP growth and inflation, but also earnings growth. 

“Hence, our preference is for sectors and investment styles which we expect to be lifted by reflationary tailwinds. We highlight financial stocks and in particular banks. In addition, many other segments offer opportunities in an expanding business cycle such as consumer discretionary, information technology or healthcare.” 

Within healthcare, concerns regarding drug pricing legislation should fade following the repeal and replace debacle, though even if this were to materialise, this should cause only a temporary setback. “Under either scenario, there will be high demand from large-cap pharma companies for ways to increase future sales,” says Mr Riniker. “This bodes well for further merger activity in the sector and can drive valuations of biotech stocks higher.” 

To be avoided are sectors which perform negatively in a positive macro environment with rising leading indicators and rising bond yields, he adds, listing consumer staples, utilities and telecoms. “Furthermore, we are currently cautious on industrials which we perceive as being overvalued.”

Yet despite believing the US is in good health and seeing plenty of opportunities, Julius Baer is underweight US equities and prefers the eurozone, a position shared by JP Morgan Private Bank.

“We are now at a point that we are telling clients that we like the US equity market, but we don’t love it anymore,” says Julien Lafargue, European equities strategist at JP Morgan. “We feel that the expectations need to meet reality at some point.”   

Active or passive?

Investors looking to access US equities would do well to consider the ETF route, believes Chris Mellor, executive director, equity product management at ETF provider Source. “The standard mutual fund route leaves you with the problem that the US is one of the most transparent and best researched markets in the world, so you tend to find it is the market where active managers tend to struggle to outperform,” he explains.

Mr Mellor points to Spiva reports from S&P, which looks at the performance of funds and shows how active managers underperform after costs. The evidence clearly shows active managers fail to outperform, he claims. 

“If you are paying for an active manager you want them to outperform, and you have to be pretty good at picking the right ones if something like 90 per cent of them underperform. Even if you pick the best performing manager over the last three years, chances are he won’t do so well over the next three.”

A simple index tracking approach could prove the easiest and best performing way to gain exposure, says Mr Mellor. “You can pick ETFs that allow you to target specific sectors that might benefit from any boost to the domestic economy, or those that are more protected if you are concerned things are looking stretched.”

But with the US market having already risen sharply since the election, and with volatility likely to return, this is not the time for an index-tracking approach, claims Adam Schor, director of global equity strategies at Janus Capital Group. “Individual stock picks across cap-ranges matter,” he says.

“With all that’s going on, the US is definitely a stockpickers market,” agrees Geoff Dailey, senior analyst for US equities at BNP Paribas Investment Partners.

Protectionist measures

Donald Trump’s tirades against trade deals on the campaign trail have led many to fear that the new president favours a less global and more protectionist approach.

But such a stance would damage both the US and global economies, warns Andrew Acheson, head of the US equity growth team, at Pioneer Investments. “Negotiating better trade deals is one thing, but it take two to negotiate. I am hoping that going down the protectionist route is more of a threat than a reality. Slapping tariffs on certain countries would lead to retaliatory action and trade wars do not tend to benefit anybody.” 

Janus does not think the president will start a trade war, but must tread carefully. “Mr Trump must not upend the growing corporate confidence in the US economy and derail a recovery that depends on global trade,” says global equity strategist Adam Schor.

But it is difficult to say, which, if any, protectionist measures will really take place, says Christoph Riniker, head of equity strategy research at Julius Baer. 

“Furthermore, bear in mind that US sales exposure is very much domestically oriented, meaning international involvement is very much limited anyway. From that perspective we remain relaxed for the time being and count on the currently robust macro environment.”

VIEW FROM MORNINGSTAR: Bull market continues but small caps lose impetus

US equities continued their upward trajectory in 2017, with the S&P 500 index registering a total return of 5.9 per cent in US dollar terms for its best quarter since the end of 2015. 

The first quarter saw technology stocks leading the market, as the sector delivered strong earnings and the highest growth rate in the S&P index. Within this segment, Facebook, Amazon, Netflix and Google (the Fangs) were the strongest performers, returning an average of 15.1 per cent. 

On the other side of the scale, the energy sector was the worst performing area of the market, sliding by more than 6 per cent as investors started to question the effectiveness of the OPEC deal.

In terms of market capitalisation, small cap stocks, which were the standout overall last year, have lost momentum on the back of declining earnings and an elevated valuation. Overall, US equities look expensive on most traditional valuation measures, with the S&P 500 trading at a multiple of 21.1 times earnings. This level is well above its 10-year historical average of 16.4 times. 

The Franklin US Opportunities fund has been managed by Grant Bowers since March 2007. The emphasis is on companies with high barriers to entry, competitive advantages, quality management and attractive valuations. 

Portfolio positioning has favoured the technology and healthcare segments in the past few years, accounting for over 50 per cent of the overall assets at the end of February 2017. While 2016 was a dreadful year for this fund and many of its growth counterparts, the long-term track record remains strong and year-to-date returns have propelled the fund to the top decile.

The Fidelity America fund is run by Angel Agudo. Most of the research is done by the manager, who targets significantly undervalued companies with a skewed risk/reward profile. 

Typically, these companies would have gone through a period of underperformance, where little value is ascribed to their recovery potential, and therefore there is strong relative upside and limited downside potential. Risk management is at the core of this process. 

The portfolio holds about 50 stocks, and exhibits a value tilt, with financials and technology the largest weightings.

Fatima Khizou, Fund Analyst, Morningstar