Are Trump’s policies the right ones to make the USA great again? Will he be able to push them through? Many have been saying: “Trump’s policies won’t work, he is a dead duck” or “It’s in the price in any case”. What is certain is that, like the Brexit vote, a Trump presidency will have an effect, the question is how much.
My opinion on US financial companies is that the 16% price move since Trump winning the election still doesn’t reflect the increased earnings growth “Trumponomics” could bring about.
In this article we briefly look at:
- US president elect, Donald Trump
- What does he want to do?
- Could he succeed?
- Is a bank heaven on its way?
- What about Europe and emerging markets?
These issues are particularly important for the Sanlam Global Financial Fund as pre-Trump we had less than 30% invested in US financial companies and 40% in emerging markets. This worked well for us in 2016 relative to the MSCI World and S&P500 Indices.
Do we shift this?
Based on our pre-Trump US financial companies’ forecasts we would now switch out of these (cheap on a historical basis, but little room to re-rate for a while). But if his policies are implemented US banks are a “buy” (higher returns on equity plus a further re-rating).
Do we take that risk and increase our US financials exposure? Do we do that at the expense of a cheap but risky Europe or do we reduce our investment in emerging market banks?
US President elect, Donald Trump
Only slightly more than 2 weeks ago the commonly held opinion was that the US market would sell off 10% to 15% on a Trump victory, the US dollar would weaken and all of that would be good for emerging markets (EM).
Well, Trump won by a narrow margin (in fact he lost by about 120,000 on the total vote count, see Figure 2 below) with only 25.6% of the total registered voters voting for him and since then the US market and the dollar have been strong and the bond markets and EM’s sold down.
His proposed policies are unorthodox and, if successful, will usher in a different era (possibly like the Republican eras under Reagan and Bush).
Those who say he won’t succeed ignore his background:
By his nature Trump is an anomaly and anti-establishment. He was heavily influenced by Vincent Peale (Author of The Power of Positive Thinking) and grew up as an individual who believes his presence will change the structure surrounding him. Hence his tendency to shape the environment around him rather than being shaped by the environment constraining him (Wibawanto Nugroho: The Jakarta Post, Nov 16 2016).
Therefore don’t ignore the possibility of wholesale upheavals of existing policies – he cast aside a long list of conventions on the way to an unlikely win, he is unlikely to be conventional now.
What does he want to do?
Essentially he wants to make America “great” again by changing attitudes and reversing 8 years of liberal-socialist thinking (read “Believe in America” an article by adventuresincapitalism.com). His objective is to create jobs and he wants to do that by increasing the USA GDP growth rate to 4%. Few give him a chance of succeeding, and many economists say it can’t be done, but even less thought he’d win the election.
So his objectives are:
- 4% GDP growth
- Job creation (he hasn’t been specific in terms of targets)
How does he plan to do this?
- Lowering US corporate tax rates from 30% to 20% (he initially stated 15%),
- Reverse regulation that has burdened the economy and is inhibiting growth, especially regarding banks and the oil and gas industries: “We want to enable banks to lend again”
- Anti-global trade: A return to tariff protection to keep jobs in the USA (curb imports and promote US manufacturing jobs).
- Push infrastructure spending. Note that the process of identifying projects, planning, approval, awarding tenders, etc. takes at least 3 years before anything happens on the ground – so a potential positive for his second term.
Can he succeed?
I hear many debt investors saying: “If yields go up more I will add long-term securities, in the long-term deflation will continue… besides, I doubt Trump’s policies will materialise…”
This is the danger. Will he succeed? Rather than making the USA great again, will he “make inflation great again”?
Since being elected we’ve seen Trump, the businessman (and he has come across much better than when campaigning, possibly because he is less in the spotlight).
Simply by threatening to play hardball he has improved the US’s negotiating position.
His proposals are not novel: Considerable research has been done on the various policies, especially both restructuring the tax code and tariff protection. The stumbling block has always been a Democrat president vs a Republican majority in Congress/Senate or vice versa plus the many partisan interests that pull strings via paid professional lobbyists. A Trump presidency could bully important changes through the process and one thing is clear: the USA has wanted a simplified tax code for many, many years. A lower tax rate and simplified tax code will be a huge benefit to the USA.
Wage inflation was a threat pre-Trump, so increased employment from the current base will further increase inflation risks. It is important to note interest rates have never been this low with unemployment levels where they are.
Growth policies could “make inflation great again” and result in a more normalised world with higher interest rates. We’re potentially witnessing the end of “the new normal” we’ve gotten used to.
Is bank heaven on its way?
In our pre-election article (“Brexit was bad, but US elections won’t have the same effect” ) we wrote that a Trump victory would be good for financial shares. Why? Because the combination of the factors below sound like “bank heaven”:
- higher interest rates – in small doses this is very good for banks,
- lower tax rate – good for bank profitability and improves the financial health of their clients
- a reversal of onerous regulation; good for
- reduced cost pressures,
- possibly even reduced capital and most important,
- increased investment and lending demand.
Het Financieel Dagblad ran an excellent article written by Peter Blom on 3 October 2016: “Huidig banktoezicht is groot gevaar voor sector”>saying: “Je kunt op elke hoek een stoplicht neerzetten, maar dan staat het verkeer altyd stil.” (Current bank oversight a big danger for sector. You can put a traffic light on each corner, but then the traffic doesn’t move)?
Trump wants to get the traffic moving again. Trump wants to make it possible for banks to lend again.
US financial companies have gained 16% since 9/11. So the question is, are the changes reflected in the valuations?
For 6 months we’ve been communicating (“US financials, unloved and growing shareholder value despite challenges” ) how undervalued financial companies were and how the market was ignoring the fact that they have been growing, and continued to grow shareholder value at 10% per annum.
The initial price move we’ve now seen was exacerbated by the fact that investors had very low exposure to financials (especially banks). The Trump trigger forced those that had ignored the undervaluation of banks to reduce their underweight position.
I can’t help but point out that this is Value Investing 101. When a sector is undervalued I often read: “cheap, but can’t see the trigger…” The lesson is that the trigger can seldom be foreseen. By definition it must be unexpected.
When a sector/share is sound, generating good returns and undervalued, you invest and be patient. The re-rating trigger will come in due course.
A quick calculation using JP Morgan as an example shows that, assuming Trump being mildly successful, the initial knee-jerk we’ve seen is not enough (Figure 3):
For our forecasts to December 2019 we simply:
- increased the net interest margin by an additional 25 bps (in addition to 70 bps we did have),
- decreased the tax rate to 25% in fiscal 2018,
- reduced the OPEX growth rate somewhat, and
- decreased the dividend cover.
Now it’s a proven fact that analysts, economists and strategists can’t forecast. That’s why value oriented portfolio managers like investing when the valuation reflects disappointment. So value managers will find it difficult to justify buying financial companies after this rally. But can one ignore the possibility that the environment will change? Does the potential upside justify taking the risk? We think it does.
What about Europe and emerging markets?
US long bond yields have shot up to 3%. This will increase EM cost of funding (yields up about 70 bps to 100 bps) and could slow down EM growth.
The natural reaction of the market was to sell EM and buy US. This was not irrational.
Our recent (past two weeks) company visits in India, Indonesia and Thailand however confirmed our views that these countries have improved their budget and trade deficits, now have lower inflation and a lower debt-to-GDP. In other words, they are fundamentally healthier than they have been in many years and are ready for the next positive cycle driven by internal polices but aided by improved commodity prices. A stronger US dollar might not initially be good for EM, but bear in mind, EM currencies did depreciate significantly between 2013 and 2015 and are not overvalued. Besides, a stronger US economy and higher commodity prices over time is good for emerging markets.
In Europe however political risk is increasing: the Italian referendum lies ahead (4 December 2016) with thereafter elections in France, Germany and the Netherlands. Just like a Trump win was not discounted in the market, it seems as if a negative outcome and a shift towards a different/fragmented Europe isn’t discounted either.
On that basis I continue to prefer selected EM banks over European financial companies. But there is a more important reason:
Political events can cause big changes in the macro outlook and hence significant short-term price moves, but our experience is that in the long-term company managements have a longer lasting (and more predictable) effect on company valuations and hence share prices.
When a great company operates in a dynamic environment the result is dramatic. Over the past 25 years the funds I’ve managed at Old Mutual, Coronation and Sanlam have always benefitted from the teams’ ability to spot opportunities like PSG, Capitec, Sasfin, Coronation, Yes Bank, TSKB, Bank of Georgia, Shriram Transport, Panin Securitas, Scor, One Savings Bank and many more. In Figure 4 below I show how one of the winners, Yes Bank (a very entrepreneurial bank in India), over the past 11 years’ has substantially outperformed JPMorgan making the shifting and changes in the macro environment over those years seem irrelevant. But one needs the longer-term lens to see that.
Banks like JPMorgan, US Bancorp and ING have superb managements, but cannot consistently generate the same ROE (return on capital) than their EM peers. Over time the EM financial companies have and will continue to significantly outperform the best in developed markets. Figure 4 shows why: Over time the value created by good management outstrips the effect of short-term macro moves.
(Refer our article on US financial companies that show how JP Morgan and US Bancorp have outperformed the other USA banks over the past 11 years)
During the two weeks after the election Bank of America’s share price jumped 20%. This was an unpredictable event. Over the longer-term the far more predictable event is that the good EM financials will continue to grow shareholder value at 15%-20% per annum.
Trump won by the narrowest of margins. But markets don’t care by how much he won. They react immediately. So far it seems his actions will support the pressures that were already building up: higher commodity prices, increased employment in the US, inflationary pressures and higher interest rates. The change his administration could bring is the reversal of growth retarding regulation and the possibility of a lower tax rate in the USA.
But, the Donald Trump that we got to know as candidate hasn’t changed. He remains egotistical, reactionary, divisive, unpredictable and based on his campaign even untrustworthy. His presidency brings increased uncertainty with potential of big blow-ups.
US financial companies are currently very undervalued relative to their past history. Hence in the Sanlam Global Financial Fund we increased our US exposure somewhat, but at the expense of Europe. Be it the USA, Europe, UK or EM: Whilst being cognisant of macro risks, we continue to prefer investing in managements that have a long track record of growing shareholder value, as long as they’re undervalued. We don’t think a Trump presidency will have a significant long-term effect on the EM banks we’re invested in.
Over time that is the most certain way of generating good investment returns.
At the same time the fund’s investment in US financial companies will benefit from the steeping of the US yield curve and if he succeeds in bringing the US tax rate down.