Causeway Research Commentary
November 9, 2016
The US Presidential election result is not Brexit 2.0
Donald Trump’s surprise win in the US presidential election has drawn parallels with the unexpected June 23 “Brexit” result in the United Kingdom. Yes, both votes represent a rejection of the status quo and a rejection of policies by disaffected parts of the electorate, but the comparisons end there. In Britain, the conservative party has, over the years, been ambivalent at best toward the European Ideal, and successfully mobilized a vote in favor of withdrawal. Mr. Trump’s election by voters demanding change in Washington DC may upend several of the economic and political policies that the Republican Party has pursued since the end of the Second World War.
Many of the sound bites uttered in the heat of this election battle contrast with mainstream Republican orthodoxy. Despite the stability that results from control of all three branches of government, the overseas markets’ initial reactions reflected this apparent conflict, as well as uncertainty for how US economic policy may be conducted. European markets, after an initial sharp sell-off, stabilized and—taking a cue from early strength on Wall Street—rallied into the close. We anticipate developed Asian markets may follow suit, but further developments could change that. We have already witnessed significant swings in foreign exchange markets, particularly the Mexican peso, and weakness in emerging markets adversely affected by Mr. Trump’s anti-trade rhetoric.
Both the US and European equity markets have quickly identified the early winners and losers from a Trump presidency. Thus far, markets have favored companies expected to benefit from the economic themes Trump espoused during the election campaign, including investment in infrastructure and revitalization of American-sourced materials and manufacturing. Companies shunned by the markets included those reliant on commerce with Mexico and those likely to suffer from a dismantling of the Affordable Care Act (“ACA”). Even though the S&P 500 Index closed up slightly above 1% today, we observed a wide 35% difference between the best performing and worst performing stocks in the S&P 500 Index.Cluster 1: Financials (Positive) and Materials (Neutral)
We currently expect that the impact of a Trump presidency, and Republicans controlling the US Senate and House of Representatives, should invigorate the US economy, especially if the US corporate tax rate becomes more globally competitive. Assuming the Trump campaign represents the presidential agenda, we expect that there may be both tax cuts and fiscal stimulus in the US, a net positive for the domestic financial sector. However, trade barriers may dampen economic vitality (in the US and abroad), adding inflationary pressures as consumer choice could decline and the prices of goods could rise. We expect the US Federal Reserve (“Fed”) to remain independent, and yet still dovish in the next year as the direction of the US economy remains uncertain. Most global sovereign bond yields have risen significantly in the wake of the US Presidential election, with the US 10-year Treasury note yielding over 2%. After rising about 50 basis points in the past three months, the 10-Year Note rose 18 basis points in this first trading day after the election result.
Although the Trump campaign promised US $500 billion of infrastructure spending (over an unspecified time frame), the new president may encounter some resistance in a Republican Congress, with its historical penchant for fiscal austerity. We remain cautious on metals stocks, as their valuations do not offset the risk that the imbalances in the Chinese economy may offset US infrastructure-related demand for cement, steel, etc.
In the financials sector, well-capitalized banks engaged in self-help to restructure and improve returns on capital remain our primary focus. A steeper global yield curve removes some of the revenue pressure on banks and will likely shorten the waiting period for greater capital returned to shareholders. We believe life insurers should also be net beneficiaries of the post-Trump environment, as gradually higher bond yields should bolster returns. As for financial regulation, we do not currently expect a dismantling of Dodd-Frank, especially in the wake of the Wells Fargo scandal. However, more stringent banking reforms may flounder with waning political support for these restrictive measures.
Without greater clarification on the actual Trump agenda, we have not immediately changed our price targets. However, we remain optimistic that our financials and materials holdings will continue to deliver satisfactory results in the quarters ahead.Cluster 2: Technology and Telecommunications (Neutral)
The single greatest driver of US technology earnings improvements and possible valuation multiple upgrades would result from a reduction in US corporate tax rates. The mooted Trump 15% corporate tax rate could be the catalyst for the repatriation of approximately $2.5 trillion by US companies, according to estimates from Capital Economics. US technology companies often have large amounts of cash earned and held abroad. The repatriation of that cash under a fairly sanguine tax treatment could lead to substantially increased dividend and share buybacks, value added merger and acquisition activity, or even debt reduction.
For our Asian mobile telephony stocks, we currently do not believe that this political development in the US will have a significant impact on earnings. For many of these holdings, data usage and pricing trends remain paramount, as populations become increasingly dependent on mobile telephony and their related applications. These Asian telephony giants are, in our view, well positioned for increased domestic wealth and rising intensity of data usage.Cluster 3: Energy and Utilities (Positive Oil & Gas, Neutral/Negative Utilities)
We believe US shale oil & gas producers should get more federal government support for their activities, with less threat of regulation. We remain bullish on the crude oil price, and believe the supply constraints can put the market in equilibrium by early 2018. We are watching for critical technological breakthroughs in solar power and power storage to make a greater impact on the energy sector than a shift in US political sentiment.
We expect regulated utility stocks to underperform in a rising bond yield environment. We continue to be confident in a select few European utilities trading at sizable discounts to fair value while engaged in major operational improvement.Cluster 4: Industrials (Positive)
The potential for lower US corporate taxes, infrastructure spending – in both the US and in the UK - and rising bond yields should continue to provide an impetus for the market rotation from defensives to cyclical stocks. We are optimistic about well-managed companies that are global leaders in the industrial equipment, power, automation, transportation, and defense industries, as well as construction-related stocks.
Despite the Trump campaign rhetoric, we do not expect a dismantling of trade relations with China, nor with Canada and Mexico. The embedded and highly complex nature of supply chains does not allow for a rapid shift to domestic US manufacturing. In the US, such a shift would require an unlikely level of federal and state government subsidization. While the UK government has effectively agreed to pay a Japanese automaker to expand operations in Great Britain, the scale of US offshoring makes such an arrangement fiscally cost prohibitive.Cluster 5: Consumer (Neutral)
With a broad-based income tax cut, and possibly lower health insurance premiums, the US consumer may have a greater propensity to spend in the next few years. From a value perspective, we remain confident that our consumer holdings will benefit from a positive wealth effect in areas such as apparel and tourism. We are avoiding the most expensive stocks known for their high dividend payouts, and assuming these high-dividend payers have limited growth prospects. A rising bond yield environment has already sparked a global market rotation from these expensive sectors, such as consumer staples, into more economically sensitive areas of the markets. We are interested in maintaining portfolio weights in some of the best-managed consumer staples companies, but only if they are engaged in operational restructuring and cost cutting plans that will add demonstrably to cash flow and to dividend growth.Cluster 6: Health Care (Positive)
Following the election, the valuation discount on pharmaceutical companies has narrowed, as a Clinton presidency threatened drug pricing. Some valuation discount remains, however, and Mr. Trump has endorsed US drug re-importation and direct negotiation with Medicare, but we currently do not expect these areas to become major goals of the new administration. US pharmacy benefit manager consolidation has already put pressure on drug pricing, and this may obviate the need for further regulation.
As for Obamacare, Mr. Trump has stated his intention to repeal the ACA. Even a weakening of the ACA could benefit well-diversified managed care companies in the US. We have no direct exposure to those “expensive” Medicaid-oriented managed care companies, and their lack of diversification may finally become a serious liability under a Trump administration.
For the highly cash generative healthcare companies, especially pharmaceutical and biotechnology firms, the ability to repatriate cash in a lower tax regime could prove especially beneficial.Emerging Markets
The Trump presidential victory is likely to have a negative impact on emerging markets currencies and trade, though uncertainty will prevail until actual policies are clarified. Regardless of whether the Fed will raise rates in December, the US dollar will likely strengthen against many emerging markets currencies. The Mexican peso has been an early victim of the Trump victory, declining roughly 8% compared to the US dollar in this first day after the election, due to expected restrictions on immigration and challenges to the North American Free Trade Agreement (“NAFTA”). The Turkish lira and South African rand are also down approximately 2% because these countries are more dependent on external financing. These types of currency moves in emerging markets will likely impact monetary policy and may prevent certain central banks from easing. Policymakers in Mexico and countries with high current-account deficits may respond to currency weakness with interest rate hikes.
From a trade perspective, global trade may face more constraints in the years ahead under a Trump administration. The Trans-Pacific Partnership (“TPP”), which would have linked nearly 40% of the global economy including much of the Asia-Pacific region, has diminished prospects. The disposal or renegotiation of trade deals such as TPP and NAFTA would disproportionally hurt those economies with a significant dependence on exports such as Taiwan, India, South Korea, and Mexico. We expect more domestically focused economies, such as China, Thailand, and Indonesia, to be less affected. Certain geographies, most notably Russia, may be positively impacted by terms of trade if Mr. Trump takes a softer stance on existing sanctions.
We believe the Causeway Emerging Markets portfolio remains well balanced to manage the incremental market volatility. We remain underweight South Africa, slightly underweight Mexico, and overweight Russia and Thailand compared to those countries’ weights in the MSCI Emerging Markets Index. We do have exposure to some of the more export-driven Asian geographies such as Taiwan and South Korea, however we believe that the cheap valuations and positive macroeconomic backdrops in these countries should offset the potential negative impact on trade. Additionally, given our quantitative approach to stock selection, we can react efficiently to changing investment opportunities going forward.Portfolio Management
Thus far, our clients with exposure to developed market pharmaceuticals and industrials have benefitted from rallies in these industry groups. We expect markets to over-react in the short term to both positive and negative implications of the election outcome, which will present opportunities for our disciplined investment approach. As was the case after Brexit, we are monitoring portfolios across all of our equity strategies, both for opportunities to buy stocks that have become undervalued and to sell those that have become overvalued in the rush to predict winners and losers from the election result.This market commentary expresses Causeway’s views as of November 9, 2016 and should not be relied on as research or investment advice regarding any investment. These views and any portfolio holdings and characteristics are subject to change, and there is no guarantee that any forecasts made will come to pass. Forecasts are subject to numerous assumptions, risks and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented has been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy or completeness of such information.
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