The rejection of Geert Wilders’ PVV party in the Dutch election has temporarily halted the drift to the political Right we had witnessed with the UK’s decision to leave the EU and the election of President Donald Trump – and France/Germany credit spreads tightened in response. But we are mindful that France goes to the polls in April and the electorate could yet back Marine Le Pen and her anti-EU platform, although analysis indicates that she would need to secure around 10 million votes to swing a victory between the first and second round of elections. Even so, a further march to populism and an eventual ‘Frexit’ would place a lot of pressure on risk assets, not least the European financial system and in particular the banking sector, which is lacking capital in many areas.
But it is the US that has been dominating our thoughts in recent weeks. We had been neutral on US equities for eight months going into the US election and the ensuing rally. Much of that rally was based on policy proposals that the market considers positive, in particular President Trump’s plans for corporate tax cuts. Analysts estimate that for every 5% reduction in the corporate tax rate, S&P500 earnings would rise by 4.2%. This translates to a 17% boost to earnings and dividends from Trump’s tax plans this year (and every year thereafter). By early-March, the market was already up by 15.5%, despite none of Trump’s policies coming through – it is now more likely that any ‘good Trump’ policies will be pushed back to 2018, or may never happen at all.
The market had clearly shrugged off any detrimental impacts of the President’s policy proposals and we believe the S&P has run ahead of solid fundamentals and economic data, and as a result strength has been overstated. We also believe US equities are fully valued, with the S&P priced at 22 times trailing earnings – this is at the upper end of historical premia to the MSCI ACWI.
Re-rating has driven the lion’s share of returns in recent years, and we are not confident that this can continue, particularly as the Fed ‘removes the punchbowl’ by further raising interest rates. There are also risks to equity markets from tighter monetary policy and a lack of expected fiscal stimulus, the combination of which would likely have negative consequences. On the fiscal front, the legislative process to pass the new US administration’s proposals appears to be longer than hoped, with meaningful gaps between perceptions in the House and Senate (notably on Border Adjustment Tax) and reports of dissonance within ‘Team Trump’.
Finally, corporate profits are likely to be eroded by higher labour bargaining power as US wages rise, while return on expenditure may also be negatively impacted depending on if and how interest rate deductibility is implemented.
Moreover, the rich valuation of US stocks must be looked at in the context of meaningful returns from elsewhere, such as Europe and Japan – those other areas are competing for money.
Portfolio positioning
Taking all these factors into account, in early-March we decided to downgrade US equities from neutral back to negative, though we remain neutral on equities overall (and currently favour Japan and Asia ex-Japan). A US equity market correction is, on balance, likely to be positively correlated with fixed income, especially US government bonds. It is worth noting, however, that while the Fed has brought forward the timing of its rate hikes with the recent rise, it is not expected to increase the magnitude of further rises.
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