Picking stock winners during Trumponomics
Best bets: tax cuts, inflation and trade protectionism
“If you’re not confused, you’re not paying attention." – Tom Peters
You can be forgiven if you find Trumponomics confounding. True enlightenment of the subject requires transcendent doublethink. For example, President Trump's ability to reconcile wanting both higher interest rates and a weaker US dollar, or his desire to balance the budget while cutting taxes.
Political and economic reality will prevent such “have my cake and eat it too” scenarios from coming to fruition. Still, based on Trump's statements, key staff appointments, and Republican control of both the Senate and House of Representatives, we can still divine the tenants of Trumponomics that are most likely to play out and their potential impact on investors.
Both the President and Republican leadership of both houses of Congress are fired up about tax cuts and reform, particularly for the middle-class. The middle-class also likes the idea of tax cuts for the middle-class, so it’s a safe move politically.
Lower corporate tax rates may also be on the cards, which would be a boon to corporate profits.
Very roughly speaking, and with all kinds of things held constant, a typical US business that would see its tax rate drop from, say, 39 per cent to 24 per cent would experience a 24.5 per cent increase in after-tax earnings from its US operations. It's a big bump and explains much of why the S&P 500 gained 11.4 per cent after Trump's election through to 24 February, despite the risk of rising rates.
Investors might want to temper their expectations when it comes to the size and timing of lower corporate taxes, though. Taxation is complicated – the US federal tax code runs to thousands of pages – and the President's plans also do not seem to flow with the House leadership’s dream of a revenue-neutral plan that incorporates a border adjustment tax.
That’s all to say, expect tax cuts for everyday Americans, which could fan the flames of both growth and inflation, but don't hold your breath on when corporate taxes will follow suit.
America first and trade protectionism
President Trump could not have summed up his world view any more clearly when he uttered the phrase “America first”. He has already withdrawn the US from the Trans-Pacific Partnership and it probably won’t be the last protectionist trade measure he enacts.
Trade protectionism is a net negative for global growth and, depending on the speed and severity of what Trump is able to push, could punish US consumers. Ironically, the latter may end up being free trade's ace-in-the-hole.
The President has pounded the table on ripping out “excessive regulation”. He has now signed at least three executive orders aimed at rolling back regulations, including one that directs federal agencies to identify at least two regulations to be repealed for each new regulation.
The slashing of red tape is a long-term positive and should unleash a little more entrepreneurial spirit. However, inertia is hard to overcome and investors should not expect miracles. The effects will make for a slow burn and it is not as if the US isn't already home to the world's most innovative companies.
Investors have already moved to make the most of Trumponomics. Still, I think they have overrated some strategies and underrated others.
Overrated: higher commodity prices
Investors were quick to latch on to the potential for a vast Trump-led infrastructure program to boost commodity prices. It is true that even small tilts in demand can bring about large changes in the price of commodities and such a trade makes intuitive sense.
I am sceptical that Republican Congressmen, many of whom are so dogmatic about deficits that they pushed back on the US$700-billion asset relief program during the darkest days of the GFC, will now support a US$1-trillion stimulus program when jobless claims are already running at their lowest levels since 1973.
Even if such plans were enacted, the impact would be spread over many years and not begin in earnest anytime soon, giving commodity producers years to gear up for higher demand.
Oh, and commodity prices have already been on a tear – iron ore is hovering around a 30-month high – so investors piling into this trade may be a little late to the party.
Underrated: US valuation risk
The world's largest, most influential equity market has been on a tear since the election, over the past year, and pretty much over the past eight years. The S&P 500 now sells for just under 25 times trailing reported earnings – a valuation that takes in a lot of optimism, especially given rising inflation and bond yields.
Practically speaking, it means that equity investors the world over should be a little more cautious when it comes to the prices they are paying for shares.
Speaking of high valuations, investors may be getting a little too complacent when it comes to current low volatility.
According to Bloomberg and some calculations on my part, the S&P/ASX 200 VIX – a measure of expected volatility – ended February at a lower level than it has for 92 per cent of the nine-plus years of the measure’s life.
Investors expecting continued smooth sailing might want to brace themselves, given high valuations and rising rates.
Underrated: inflation protection
Global investors are not too concerned about inflation these days, given that it has spent years hovering below the comfort zone of most central banks in developed markets. Indeed, the yield on 10-year US Treasury bonds of 2.3 per cent at the end of February sits below the 2.5 per cent year-over-year increase in the consumer price index.
Inflation ramping up is a risk worth watching closely, though. US inflation has accelerated to the highest levels since March 2012 and a tight labor market, higher commodity prices and the potential for higher deficits, could act as accelerants.
The conventional way to play inflation in equity markets is to be long in commodity producers, asset-heavy companies of many stripes, and companies with fixed debt burdens that will feel magically lighter if inflation ramps up.
Commodity prices have already run, though, and companies with high reinvestment needs must soak up more of the burden of inflation in their own costs. Also, I tend to prefer companies with lots of cash rather than debt. A mediocre business with no debt can recover from pneumonia, while a good business with piles of debt can be killed by a common cold.
Perhaps a better solution is to focus on companies with light reinvestment needs and who can pass along price increases to a loyal base of longtime customers. Rest-easy balance sheets are a plus too.
Shock events such as Brexit and Trump's election are stark reminders of the importance of diversifying one’s wealth across asset classes, markets, industries, risk profiles, and even varying degrees of liquidity.
The value of diversification shines through at the investment level, as well, as companies with diverse suppliers and customer bases tend to have less of a chance of a shock event pulling the rug out from underneath their business model.
The bottom line
Understanding Donald Trump’s true intentions is difficult but discerning political reality is much simpler. Likewise, it is plain that diversification plays an important role in portfolios, that commodity prices have already run a long way, US equity valuations are high and Australian volatility is low by historical norms, and inflation is picking up in the world’s largest economy.
I remain long-term bullish as ever, but the broader backdrop leads me to believe investors can be a little more patient than usual.
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