Robert Swift
Are equity investors too sanguine and is 2017 a year of reckoning, when the increased political uncertainty and the end of easy money, is reflected in lower PE ratios as equity investors reduce exposure in favour of ‘safer’ assets? It’s been a few years since we had a negative year for equities. Is 2017 the year?
Financial markets invariably face hurdles such as economic and political risks, valuations, and management changes. In fact, it often said that ‘markets climb the wall of worry’, so these hurdles are not always a bar to making good returns from equities. 2017 will be no different but Donald Trump seems keen to provide a set of new challenges.
The inauguration speech was rather chilling. He emphasised the US jobs lost and loss in wealth of Americans due to globalisation, and what he believes are unfair practices by the Chinese and a very disadvantageous NAFTA deal with Canada and Mexico. This sounds like protectionism to a world used to free movement of capital and increasingly free movement of labour.
The problem with starting protectionist policies is that it is a race to the bottom where everyone loses as prices rise due to retaliatory tariffs being levied by both sides, and trade volumes and spending shrinks magnifying the downturn. This is what happened in the 1930s after Smoot and Hawley, two Congressional politicians, introduced punitive tariffs on imported goods to protect American farmers.
The US could increase tariffs on certain Chinese imports where there is an element of state interventionist “dumping” like steel, but China can retaliate because US carmakers sell a substantial number of vehicles, imported raw materials, and iPhones there. Both sides typically lose. Of course, the trade imbalance is substantially in China’s favour so China would hurt more, but US consumers would be likely to pay more for their goods. China could substitute European goods or raw materials from elsewhere, so Europe could be an inadvertent beneficiary of a China-US trade war.
But protectionism doesn’t just come in the form of tariffs and import restrictions. The President can also veto takeovers perceived to be detrimental to the national interest and could also introduce legislation to restrict overseas companies buying US listed and privately held companies. Of course if he were to do that, then other countries are likely to follow suit with similar legislation of their own. Once this starts happening all companies with some element of takeover premium in their share prices drop and so markets end up lower.
Additionally, the Chinese are major buyers of US government debt and it is conceivable that they would dump this debt driving prices lower and yields higher. This would have an impact on the USA financial and corporate scene unless the USA can find other buyers for its debt at the same price. Recently the Chinese ceased to be the largest foreign owner of USA debt to be replaced by the Japanese. How much more USA debt will the Japanese buy? Probably a lot if the USA plays ‘big brother’ in Asia but the Chinese were big supporters of US debt issuance and their withdrawal will not be easy to replace?
Interestingly the Federal Reserve has just signalled it wishes to reduce its balance sheet so there will be more than just new USA government debt being sold into the market place. Approximately US$ 1.3 tln of existing debt matures this year which the Federal Reserve will no longer be buying. Indigestion is a real risk. US institutions might have to be ‘persuaded’ to buy USA debt which would be a form of repression. It wasn’t so long ago that banks were obliged to hold a certain portion of their assets in the form of government debt. (This has been happening sotto voce in Europe incidentally).
It’s not all negative. Trump did highlight in his inaugural speech his commitment to infrastructure spending, where he highlighted the run-down state of US roads, bridges, airports etc at the expense of overseas wars. There are no concrete figures on this idea but $1tn has been the figure bandied about. He is also talking about corporate and income tax cuts as part of a tax reform package!
Put together these would lead to a substantial rise in US government debts unless the GDP growth rate increases. The US Debt to GDP ratio is already at 104% there isn’t much room for error and there are implications for interest rates, from which equity valuations are derived. The US 10 year Treasury yield currently sits at 2.5% so we are likely to see further upward pressure on interest rates from such policies. He is also said to be targeting a US GDP growth rate of 4% – substantially above the current run rate and current forecasts – a figure that would be consistent with fiscal reflation and substantially higher borrowings. (Frankly given USA demographic trends this is a virtually unobtainable GDP growth number. Additionally, and counterintuitively, he wishes to worsen demographic trends through a much harsher immigration stance).
His speech also highlighted the unfair burden placed on the USA by its NATO partners. NATO members are obliged to spend 2% of their GDP on defence expenditure, yet as the table below shows currently only 5 of the 28 members honour this commitment. In fact, this has been happening for years but no US President has been sufficiently forceful to change the situation. If President Trump were to be successful in this area this would be a significant boost for European defence manufacturers like Airbus, Leonardo, Thales, Safran and BAE Systems.
It isn’t just the USA that presents a challenge in 2017
However, France is different and as a bigger economy it is critical. The French Presidential election takes place in 2 rounds between the 23 April and 7 May. Anti EU sentiment has risen substantially in recent years. Increased immigration, terrorist attacks, and poor economic growth are the root cause. While the far right National Front led by Marine Le Pen, has risen significantly in the polls, she is very unlikely to become President. Francois Fillon, head of the conservative Republicans party is the more likely winner. Often described as France’s Margaret Thatcher, he advocates significant economic reform – abolishing wealth taxes, and cutting back the role of the state and reforming public health care. His election would likely be good for the French stock market. We think this will be a positive surprise in 2017 and a boost for European equities in general.
The German Federal election takes place on the 24 September where Angela Merkel seeks to retain her position as Chancellor. Mrs Merkel has been heavily criticised for welcoming over one million migrants from Syria and elsewhere and this has boosted support for the far right AfD from 5% in the polls in 2015 to over 15% today. Mrs Merkel will depend on the absence of bad news for re-election. She may just get it if M. Fillon wins in France and promises to reform the economy.
Overall, we see a rise in support for Eurosceptic parties but they don’t win. The EU remains oblivious and intransigent to the message from ordinary voters so it is rather doubtful that we will see too much change in the way the EU is managed or its direction in 2017. We don’t see the Euro break apart.
So what do I do? Equities vs Bonds vs others?
We could see higher growth coming from the USA as President Trump outlines his reflationary policies in the first 100 days of office. A more probable lift to equities would be an asset allocation shift from Bonds to Equities. Since the 2008 Global Financial Crisis there have been an overallocation to Bonds relative to historic norms, accelerated in particular by the policy of Quantitative Easing as bond yields were driven by central bank policy.
In fact, evidence of more reflationary policies from the USA may indeed trigger the shift out of bonds, as US bond yields rise inflicting losses on bond holders. Nothing causes investors to move more than losses! But of course the extent of protectionist policies needs to be ascertained before investors feel comfortable in making this move.
In recent years, safe and defensive stocks have outperformed and, the market has seen little disparity between the best and worst stock. This will change in 2017. 2017 may be a year when there is merit in focussing upon cyclical rather than safe companies. Cyclical companies have learned to live with a difficult revenue environment by cutting costs and consequently have very strong operating leverage. Any revenue pick up will see their earnings take-off. We purchased Dow Chemical recently for this reason. Financial stocks have been the ‘whipping boys’ for many years and have been hit with fines, lawsuits and a mountain of legislation. This could be over. These stocks are cheap compared to “safe” stable shares which have been bid up because investors saw no boost to GDP or revenue and wanted safety. M&A is also likely to increase which will put a floor on valuations in certain industries. If management doesn’t improve earnings then someone else will do it for them. We are already seeing a lick up in M&A. Things have changed.
So in our portfolio we are overweight financials, overweight cyclicals and overweight Europe. The only way, for some stocks, is up!