Since the US presidential election, which saw Donald Trump win and the Republican Party maintain control of both houses of Congress, the outlook for US equities has changed dramatically. In the intervening months, our view on the possible implications of the election outcome has evolved. As investors, we are always in a position of making decisions with less-than-perfect information. In that context, we have determined what we believe to be the most likely policy agenda to emerge out of Washington and what central scenario appears to be priced into markets – and thus where opportunities may lie if markets are incorrect.
We believe 2017 will be a year of transition. In the wake of the credit crises, the US has seen a slow, gradual recovery. The US equities team expect a shift from low secular GDP growth to possibly higher growth and inflation. Stocks have been buoyed by easy monetary policy leading to historically low interest rates. There remains a broad sense that President Trump and the Republican Congress will focus on pro-growth initiatives. US equities have rallied in anticipation, but details of these initiatives are still lacking, which makes handicapping what actually might happen extremely challenging. Investors are looking for specifics about tax reform policies, the future of the healthcare system, and how spending priorities will be sequenced.
In our judgement, a pro-growth package would include:
- A reduction in the top corporate tax rate to 20%
- A significant decrease in corporate regulation
- Repatriation of off-shore corporate profits at a permanently lower tax rate (i.e. not just a temporary tax holiday)
- A significant infrastructure programme, possibly funded by the initial burst of corporate revenues brought home under the repatriation plan
- Lower individual income-tax rates
- Deficit spending
What does the Republican agenda potentially mean for US small-cap investors?
Right now, investors seem bullish about the Trump era. And really, that shouldn’t be so surprising, given that many of Trump’s top economic priorities are also long-standing business favourites: deregulation and tax cuts. Add to this the President’s recent executive orders to advance two pipeline projects and his broader plan to fix infrastructure and you can understand why investors might be optimistic about the future.
All the pieces are in place for a stimulative, business-friendly agenda designed to boost corporate profits. And remember, that’s really what investors care about the most. We know that earnings drive stock prices. Not the health of the economy as a whole, but the growth and future profitability of businesses. The consensus view is that the Trump administration should open lots of new opportunities for profit.
Of course, there is also a high degree of uncertainty. President Trump’s continuing commitment to erect new trade barriers, his willingness to bully companies and potential conflicts of interest could have big economic consequences.
Smaller companies could benefit the most…
We’ve found smaller companies benefiting from rising risk appetite. Furthermore, small-capitalisation companies (small caps) tend to have greater operating leverage due to weaker economies of scale.
We expect that merger and acquisition (M&A) activity will continue to be an important theme in assessing small-cap stocks. 2016 proved to be a cycle high for small cap M&A, as reflected in both the deal count and deal value for Russell 2000 stocks. Although fiscal stimulus and/or tax cuts could potentially steer companies away from “buying” growth, we think the opportunity to acquire technology, customers, capabilities or earnings accretion will continue to be a strong motivator.
Given fears over Trump’s trade policies, stocks with high domestic exposure, in particular small cap stocks, are likely to do better than global names and this should also benefit smaller stocks. The prospect of a rising dollar favours companies with a greater domestic orientation. In addition, small-cap stocks have a stronger correlation than large-cap stocks to US GDP growth and if growth rises, small caps would benefit. Our market view is focused on economic sensitivity.
…and more in certain sectors than in others
Industrials (and infrastructure stocks) should profit given their cyclical nature and domestic focus. Financials have rallied post-election due to the expectation that Trump will be less onerous on regulation. In our judgement, higher interest rates should encourage increased bank lending and consumer spending. Income-tax cuts could help boost household spending in the future and that may propel consumer stocks. As for the technology sector, it is our expectation that this could get a boost from the repatriation of corporate cash holdings as we anticipate more M&A in this sector. Companies can also use cash to buy back stock and pay dividends, which can help performance.
Over the last year, healthcare has been the worst-performing sector in the US equities market due to political uncertainty relating to drug pricing, a temporary slowdown in drug approvals and the potential repeal of Obamacare. This underperformance has brought the sector’s relative valuations to historically compelling levels. It may take a few months for the policy outlook to become clearer, but we believe the ultimate policy landscape will improve. We see the most significant opportunities in biotechnology stocks as we believe drug-pricing concerns are overblown and innovation remains strong.
Finally, we see a return of idiosyncratic factors driving stocks, which tends to lead to a broader dispersion of returns and thus can be a more favourable environment for stock-picking. Market leadership is becoming more dynamic, suggesting that investment selectivity is growing in importance, an implicit argument for active management.
In closing, the recent rally in US small-cap stocks has made them more expensive compared to their historical average (see Exhibit 1 below), but they are still cheap relative to large caps. In our judgement, earnings growth will justify the higher prices.
Exhibit 1: On a relative basis to large-cap stocks, small caps are trading at a level close to the average, relative price/earnings ratio for this cycle
Source: Factset, as of 06/02/17