Ever since Donald Trump’s November election win, US equity markets have been rallying. What investors need to consider is if the rally is justified.
Since the presidential election, US equity markets have rallied, gaining more than 10%. Such a rally is, in and of itself, generating uncertainties. Has the US market climbed too high, too fast, i.e. giving full credit to Donald Trump’s announced reforms? Reality may impose at least some delay especially if US market sentiment is judged excessively optimistic.
Nevertheless, the US market went up again after the President’s speech in front of the congress on February 28th. The main evolution noted was a much more presidential and traditional tone in front of Congress as opposed to a more aggressive rhetoric adopted after reaching the White House. Otherwise, we noted no major policy shift in his speech. Furthermore, President Trump gave no indication as to how he intends to finance his US$1trn infrastructure plan and defense splurge, while simultaneously reducing federal borrowing. Furthermore, we have not seen the essential details of his tax budget or infrastructure stimulus plans.
A rise in positive investor sentiment no doubt contributed to the rally. Investors were reassured about the President’s willingness and ability to implement his economic agenda of fiscal stimulus, financial deregulation and corporate tax reforms designed to support exports and discourage imports. However, what is at stake is inflation, higher interest rates and a potential new appreciation of the US dollar. Though economic expansion has been a major and positive investment theme for equity markets since mid-2016, there is nothing concrete to justify such confidence.
Probably the most important issue for US profits, therefore for investors, is the US tax reform. Equity markets have cheered the prospects of corporate tax cuts. According to different calculations, the implementation of Trump’s tax plan would increase after-tax profits by 10 to 15%. This fiscal measure is clearly supporting the equity market, at a point in time when operating margins are on the downside; a logical step when the economy is approaching the end of an expansionary cycle. As of today, the analyst consensus expects S&P500 earnings to grow by 10% in 2017 (more than 15% for Europe!).
The USD appreciation vs. most currencies (+9% vs the EUR since May 2016) is weighing on US exports, and tax measures enhancing protectionism could weigh on international trade. A ‘border adjustment’ could further appreciate the dollar, but could have a significant negative effect on the US’ trading partners and Asia/EM especially. In fact, we believe the market is not discounting the probability of such a measure. In the event it does happen, markets could be hit even harder.
The size of the fiscal package that will be passed, as well as its effects on growth, is up for debate. The timing of the proposed fiscal package in the cycle of the US economy may not be optimal. Take for example fiscal stimulus implemented under Ronald Reagan during a weak economy. What could be the effectiveness of a ‘fiscal multiplier’ on growth when the economy does not have a significant amount of slack? With unemployment below 5% and the output gap probably small, there is not a lot of room. Therefore, President Trump’s fiscal actions may have a smaller impact on US growth than expected and no real impact on productivity. Fiscal stimulus plans might even generate risk. Such a program could potentially have an overheating effect on inflationary pressures already building, pushing the Fed to increase interest rates faster than expected today with a recessionary risk for the US. As the adage goes “economic cycles do not die of old age but usually are murdered”. If stimulus were to come, it would affect 2018 rather than 2017.
In conclusion, the US economy is doing fine. There are no signs of a recession on the horizon. The problem is that the new administration intends to stimulate growth when there is no need for a boost in demand. The way the Fed will react to new inflationary pressures will be a key issue. As an equity investor, we believe that the US market is overpriced. We remain in favor of the European equity market. We have a neutral stance on the US market simply because the economy still is improving and there could be a potentially huge inflow of capital towards equity markets after more than a decade of falling interest rates.