When to Dump the Trump Bump?
While US equity prices have declined over the past week, they are still up more than 10% since Trump was elected President. On the eve of the election the stock market was virtually flat from a year earlier and economic performance has not radically changed so conventional wisdom is that most of the post-election bump in equity prices reflects expectations that President Trump’s policies will be good for economic performance and corporate profitability. Indeed, the SPX price earnings (P/E) ratio is up by about the same amount as the market so the rally apparently reflects potential rather than the reality of better performance.
As the rally seems to be based on expectations of market-friendly Trump policies, failure to deliver could lead to significant weakness as valuations revert back toward the mean. The rise in the P/E ratio has a mirror image in a decline in the equity-market average dividend yield displayed in the chart below. Equities are indeed relatively expensive since the dividend yield is at the lowest level since 2011. This has been partially offset by a decline in the 10Y US Treasury rate but equity yields even relative to bonds are low vs. the post-2011 range. While equities are relatively expensive compared to recent history they are not overpriced based on 2011 and earlier levels. Prices being high but not at historic extremes would point more to limited upside than risk of sharp decline. But there is still risk of a move back toward the mid-range dividend yield of about 2.65% if the Trump Administration fails to deliver on the policy shifts that underpinned the post-election rally. In the absence of a change in dividends, this would imply an 8% to 9% drop in equity prices.
Equity (SPX) Dividend Yield History
Corporate Tax Policy is Key for Broad Market Performance
It is not likely that all of Trump’s intended policies are equally important to the market. Indeed, we believe implementation of neither personal tax reform nor infrastructure spending are critical to sustaining the post-election rally. Trump’s commitment to reform personal taxes, in principal, could boost aggregate demand but the net impact is likely to be modest. Cuts in personal tax rates tend to be focused on high-income earners resulting in a small impact on demand (the propensity to save rises with wealth). Stimulus is also likely to be limited by efforts to offset cuts with reductions in spending and/or revisions to deductions to minimize the impact on the fiscal deficit. Infrastructure spending is also unlikely to have a dramatic impact on aggregate demand because these types of projects typically have a long lead time – measured in years – and there will again likely be efforts to keep them revenue neutral.
Corporate tax reform, contrarily, appears essential for the market to hold onto its relatively lofty pricing. The United States corporate tax rate is one of the highest in the developed world. Trump has indicated he feels high tax rates put US firms at a competitive disadvantage in the global markets causing them to move operations overseas to lower tax environments. A cut in corporate tax rates would generate immediate and direct positive impact to the bottom line, so even if there is no net impact on aggregate demand, it would be positive for profits and help bring the dividend yield picture back toward recent norms.
With US corporations holding $2-3 trillion in earnings offshore to avoid paying the high US taxes, a significant reduction in the tax rate could pave the way for repatriation. The chart below suggests that real capital formation in the US is more likely to occur when capacity utilization is tight. The pickup in investment in recent years has accompanied a reduction in capacity utilization. With the overhang of unused productive capacity, companies are unlikely to heavily invest repatriated earnings. The cash instead might be used to pay down debt and buy back stocks which could also be a factor underpinning stock prices. So we think a failure to cut corporate taxes could lead to a reversal of much of the bump.
US Fixed Investment and Capacity Utilization
SPX Post-Election Sector Index Performance
The Bump is Not Uniform Across Markets
The chart above shows the SPX index performance by sector since the election and provides evidence on which Trump proposed policies are key to the bump. The weakest sector is energy suggesting that any positive effects of deregulation are being overwhelmed by expectations of weak prices – indeed, weaker regulation may ultimately result in more supply adding to downward price pressures. In theory, the international trade restrictions being proposed for Trump would be bad for retailers – because of higher cost of imports – but good for manufacturers. Hence, the similar performance of consumer discretionary and industrial stocks suggests the market is not priced for much of an impact from trade policy. Therefore, failure to deliver on trade protection is unlikely to have a big market impact.
Financials are the topside outlier. In addition to benefiting from prospects from a positive economic environment, the Trump Administration is in the process of reversing some of the restrictions on banks imposed by the Dodd-Frank act. The chart on the following page suggests that bank stocks are particularly vulnerable to a failure by the Administration to deliver expected policy changes and/or a flattening of the yield curve. Bank stocks started to outperform the general SPX at the beginning of last summer when it still looked unlikely that Trump would win the election. Banks’ core business is using short-term liabilities – especially, demand deposits – as a way to fund longer-term lending and investments. Bank income is driven by the spread between the shorter-term borrowing costs and longer-term lending rates, so the steepening of the yield curve that gained momentum with Trump’s election has been good for bank stocks. But in recent months, questions about the prospects for continuation of growth trends and concerns on the global political environment – e.g., concerns about the Euro and risks of military escalation in the Middle East and Korea, have led to a drop in Treasury yields reversing much of the past year’s curve steepening. Even though bank stocks are well off their highs they still look overpriced and vulnerable to disappointment.
US Treasury Curve and the SPX Financials Index
Reading the Bumps
The post-election stock rally appears to be reflective of expectations that Trump Administration policies will support corporate profitability directly via tax cuts and deregulation as well as indirectly through stronger growth. Many of Trump’s high profile policies, in particular, energy deregulation and trade, do not seem to be critical factors behind this outlook so failure to deliver on these fronts should not significantly affect stock prices. We believe cutting the corporate tax rate and bank deregulation are the primary drivers of the post-election rally so failure to deliver on this front could lead to a substantial dump of the bump, especially for financial stocks.
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