April may not be 'the cruellest month’ after all. The favourable outcome of the first round of the French presidential election led to a sharp rebound in beta (risk-on), with many markets returning to, or some even breaching all-time highs. The technology heavy NASDAQ broke through 6,000 for the first time, while the DOW Industrials is back above 21,000 leaving global market capitalisation at a record $50 trillion.
The seeming reduction in political risk in Europe, revival of Trump’s tax reform plans and solid corporate earnings across the globe, appears to be setting the stage for a more measured reappraisal of the economic backdrop. Other barometers of ‘investor fear’, like the VIX (volatility) Index and 1-month Implied Volatility of EUR/USD futures both crashed back towards historical averages. Additionally, bearish investors, who expect falls, may have even thrown in the towel, after data showed that short interest in the US equity market’s most liquid Exchange Traded Fund (ETF) hit a ten-year low at the end of the month.
Investors may now be able to focus on the improving and encouraging economic fundamentals. For Europe, the PMI (leading indicator) hit fresh seven-year highs, which suggests around 3% GDP growth for the Eurozone and corresponding double-digit earnings per share growth, which would be above current analyst estimates. We believe that European equities offer some of the most attractive upside relative to other regions at present. The combination of rising bond yields, narrower spreads, continued support from the European Central Bank and improving economic backdrop are all strong supportive factors. In this environment, European financials – as a beta proxy – could be the main beneficiaries, along with stocks in peripheral countries like Spain and Italy, while French stocks could benefit from a centrist president.
Overall, we remain positive on the outlook for equities globally and feel that barring any significant change in the underlying backdrop, investors should continue to ‘buy the dips’. Perhaps rather than making attempts at ‘timing the market’, a simple strategy of ‘averaging in’ at regular intervals would enable investors to benefit from this encouraging environment.
1. Markets unconvinced by Trump’s 'biggest tax cut ever'
Now that the 100-day milestone has passed, president Trump’s trophy cabinet still looks conspicuously empty. None of his legislative goals have been achieved and, despite the flurry of executive orders, the fiscal stimulus package (tax cuts and infrastructure spending) is facing increasing doubts over its viability. Judging by his twitter activity, Trump himself is feeling the pressure, which is why his administration has unveiled what it calls 'The Biggest Individual And Business Tax Cut in American History'.
It appears that ‘shock and awe’ is the tactic here. Under the plan, the seven current US tax bands will be reduced to three, at 10%, 15% and 35%, while the corporate rate of tax will be reduced from 35% to 15%. Treasury Secretary Steve Mnuchin also floated a 'one-time' cut-rate tax of 10% to encourage a repatriation of capital held abroad by US companies.
In theory, cuts to corporate tax should bolster share prices through increased revenue. But the market reaction to the 'biggest tax cut ever' was decidedly muted. The verdict seemed to be that the plan is more a statement of intent than an actual policy blueprint, and that getting the proposal through Congress any time soon is wholly unrealistic. Why? Because there are several gaping holes in the proposal, most of them dollar-bill shaped.
Trump’s corporate tax cut alone will take out $2.2 trillion in government funds over the next decade, according to estimates. White House officials will point to the expected repatriation of foreign-held funds, while Mr Mnuchin says the higher growth brought about by the reform will plug the funding gap. But again, the numbers don’t add up. US companies hold an estimated $1.2 trillion in offshore cash piles, and the growth rate needed to offset the loss from corporate tax alone is extremely high.
Into the tail end of last year and beyond, politics was the principal driver of markets, with political risks holding markets back and political promises pushing them forward. Now it seems that market focus is back on the underlying economy, with the undergoing earnings season being the most intensely watched in a long time. There seems to be a general feeling among investors that politics will be politics, and, whether Trump manages to succeed in his fiscal plans or not, it will be the underlying economy that drives valuations. A welcome change, to be sure.
2. Q1 corporate earnings season – big banks lead the way
Investors entered the first quarter (Q1) corporate earnings reporting season looking for crucial evidence as to whether their regained confidence in the stock market was justified. On current analyst consensus expectation numbers, Q1/2017 is tracking even stronger than Q4/2016, driven by improvements in financials and energy and commodity sectors.
The health of banks in general is important, especially as they provide a conduit for further economic growth via lending. The earnings from five of the top six US banks have reassuringly come in above expectations, bar Goldman Sachs, which missed forecasts for the first time in two years. The issue at Goldman’s appears to be they merely got the ‘Trump trade’ wrong, rather than poor fundamentals.
Beyond the banks, companies listed on the S&P 500 Index could deliver their strongest earnings growth in nearly 22 quarters, on the back of an accelerating US and global economic growth, higher commodity prices and rising US rates which are particularly beneficial for financials. JP Morgan expects the earnings per share of the S&P500 could end the quarter near $30 a share, which would represent a healthy 11% jump year-on-year.
We believe that there is potential for companies to positively surprise relative to expectations, on the back of high operational gearing (to an improving economy), the base effect of higher commodity prices, better corporate pricing power and still supportive credit conditions during Q1.
If the earnings picture in the US looks good, then European earnings could be even better. While still early in Europe, earnings are delivering clear beats, especially for cyclical stocks like BMW, Schneider, ASM, Michelin, ABB and many others. We note that weekly positive earnings revisions have posted some of their best levels since the financial crisis and trends in PMIs suggest these improvements are likely to continue. On the back of these factors, flows into European equities appear to have turned a corner and more could be on their way. The ‘million-dollar’ question is whether it will be enough to appease investors. We expect that, at the very least, the increasingly marked difference between the global regions will lead to a change in market leadership, from the US to Europe and Asia.
3. Mayday in June: PM looks to silence critics with snap election
We’re now just weeks away from heading to the polling stations again. If recent polls are to be believed, the Tories could be looking at a 140-seat majority. The ‘forgone conclusion’ status of the snap election is why currency markets seemed to have taken the news of the snap election rather well. Sterling remains the biggest indicator of market confidence in the UK’s political and economic outlook. With her mandate extended to 2022, Mrs May would gain more leeway for compromises that Brussels will surely be demanding, such as continuation of the UK’s financial obligations and the rights of EU citizens in Britain. So, the currency’s spike to a six-month high of $1.29 against the US dollar can be taken as a general expectation that the election will help shore up the Government’s negotiations with the European Union (EU), ensuing a ‘softer’ Brexit than had previously been predicted.
Ultimately, for UK investors, the near term effects of Brexit proceedings will be felt through currency valuations, as the value of overseas holdings will fluctuate with the value of the pound. The Brexit cloud has been hanging over sterling for almost a year now and we don’t expect blue skies ahead. While the chance of a hard Brexit – where the UK ends up just trading with the EU under World Trade Organisation rules – might decrease with a Conservative win, its still highly unlikely that the government will emerge from negotiations getting the best of both worlds. Brexit still means Brexit, and there is “no turning back”.
It’s perhaps worth pointing out that an increased Conservative majority might be likely, but it’s not the only possible outcome. UK polls have traditionally overestimated the Labour share of the vote, a fact many pollsters have tried to rectify since the polling miss of the 2015 election. It’s possible this could have led to an overcorrection. If, though unlikely, the Tory majority was reduced, it could leave more voting power in the hands of the firmly pro-EU Liberal Democrats. Alternatively, of course, a reduced majority could also embolden the Eurosceptic wing of the Tory party. We don’t expect these situations to materialise, but it’s worth noting even the unlikely eventualities, because over the coming weeks foreign investors may come to similar views and this is likely to increase downward pressure on the UK’s currency once again.
4. Why currency moves matter in 2017
The US dollar has declined 3% since its high last year. On paper, this makes little sense. The US Federal Reserve (Fed) is firmly in the midst of a monetary tightening cycle, with consensus expectations indicating two further interest rate rises this year to follow March’s hike. In theory, rising US interest rates should make the dollar more attractive and thus divert capital to the world’s largest economy, which should push the currency up, not down. What’s more, the expected loosening of the public purse strings by President Trump should provide upward pressure on the global reserve currency.
The financial commentariat have been at pains to attribute the dollar’s weakness to political factors, exacerbated by intervention in the Syrian conflict, as well as Trump’s determination to 'solve the problem' of North Korea. In our view, the geopolitical explanation of dollar weakness misses the mark. The US is an omnipresent player on the global stage, putting them in the midst of most conflicts (directly or indirectly). There’s little evidence that such involvement materially harms the US economy or currency (except perhaps in the case of long-term involvements such as Vietnam or Iraq in the past). What’s more, with its status of global reserve currency, dollar assets such as US treasuries are considered ‘safe-haven’ investments, meaning geopolitical instability should increase, not decrease, capital flows into the country.
So why isn’t there considerable upward pressure on the US dollar? Answering this involves delving into the realm of what drives currency movements in the first place. What ‘determines’ a currency’s value at any one time is notoriously ephemeral. For a while it may be interest rates, inflation, growth or political stability, but that doesn’t mean it will always be so.
We currently expect the US economy to lag behind that of Europe, Japan and Emerging Markets (particularly China) in the short to medium term. The 3% currency depreciation may indicate that we are not alone with our expectations. The lagging effect could very well continue to pass on to the dollar, as capital is diverted away from the US. Therefore in 2017 we expect currency moves to matter more than usual, as they may generate bigger value differentials than the regional stock and bond markets.
5. Fundamentals of trade: Does President Trump know?
Globalisation has helped increase America’s wealth more than any other country, even if there have been just as many losers as winners. But ever since Donald Trump took office, his determination to bend global trade to his will has raised alarm bells with economists and investment strategists. Conventional wisdom suggests his attempts to artificially balance trade, either through imposing import tariffs or otherwise, may do more harm than good, both to the US and the global economy.
Taxing imports, or seeking to domestically produce all goods and service would significantly increase prices for consumers; while the US economy would not be able to produce nearly the same volume of goods its population currently has access to. To maintain the current average level of living standards, there has to be a degree of specialisation, not least, where the US is without the resources needed to produce a particular good or service.
Early economists like Ricardo theorised that countries vary both in their ability to produce certain goods and at how efficiently they can supply them. The US will continue to gain from trade if they produce (and export) those goods that have a relatively lower opportunity cost for them compared to other countries, while importing those with a higher opportunity cost relative to other countries. Indeed, much of America’s success in the last century can be attributed to its mastery of such trade structures. So perhaps the US trade deficit reflects an imbalance of certain factors in its domestic economy, rather than economic stealth from its trading partners.
Because the US consistently imports more than it exports, net exports are being viewed by the new US administration as a significant 'drag' on GDP. This feels misleading for two reasons. First, the more a country spends the less it is able to save; and, the more it saves the more it has available to invest. The ongoing trade deficit demonstrates the US may be spending beyond its income. But the same was true over the past four decades – while continuing to enjoy high average economic growth rates and per-capita wealth. So, it is hard to argue that it is materially, and negatively, affecting the economy or consumers.
Second, as with all countries, the US’s current account is determined by its balance of payments and imports are paid for by using foreign currency (reserves). A change in US trade policy by the new administration may therefore not have the desired outcome. Increasing the cost of imports through tariffs would simply make certain products relatively more expensive for US consumers – although this could be offset by an appreciation of the US dollar. Unhelpfully, a currency appreciation would make US exporters less competitive, offsetting any initial benefit from export subsidies, or the imposition of some form of tax on imports. So, net/net the US economy and their consumers would be worse off.
What about protecting employment and industry? It’s unlikely that protectionism would achieve either. Not least because it would likely resurrect and/or subsidise inefficient domestic production, services and industries, increasing costs to US consumers, reducing overall output and harming economic growth.
So, no wonder the new US administration appears economically naive. After all, no country has a monopoly on trade and no country is an economic island. But what if the protectionist talk is just an opening gambit? It would benefit all nations if the new US administration could bring down barriers to trade of goods, and to the trade and protection of intellectual property. China, for example, has benefitted from a somewhat one-way approach to the global trade of goods and services. Alas, such mutually beneficial trade reform does not reconcile with Trump’s rallying cry of America First. Trump may have surprising intellectual deficits compared to his predecessor, but he appears willing to listen and able to learn and compromise. Perhaps he will soon work out he would be better off spending his time in office working to grow international trade rather than smother it.