April 19, 2017
The most prominent beneficiary of the so-called “Trump trade” has been equities, with total returns of 10.5 per cent from the S&P 500 and 10 per cent from the MSCI All-Country World index since the US election.
However, pinning a global bull market on one individual is dangerous. Several other drivers have supported it, making it even more important to hold equities. The term Trump trade introduces illusory key man risks at a time when many investors should be buying in.
The rally has two main drivers. The first is a more balanced and muscular policy, adding fiscal support to existing monetary accommodation. The second is equity valuation.
In the US, policy prospects rely less on the president and more on the same party controlling all three legislative branches. Although corporate tax cuts are a likely part of any package, stock analysts have not priced them into their earnings estimates because they have not been enacted. Along with infrastructure spending and deregulation, implementation would help support stocks.
However, Trump’s US is not the only policy game in town. Stimulus in China and relaxation of austerity in Europe, the UK, Japan and Canada were boosting the backdrop long before November’s elections. The US may have provided a final missing catalyst, but economic support for equities is much broader.
Since the election, for example, analysts’ expectations for earnings per share over the next 12 months have increased by just 2.5 per cent for the S&P 500, versus a rise of 5.6 per cent for the All-Country World index, excluding the US. It is notable that stocks globally are near all-time highs despite relative setbacks for assets that are more sensitive to US reforms — including the US dollar and smaller or highly taxed US companies.
This equity-friendly attitude has reduced such tail risks as stagnation and has provided a necessary impetus for valuations to rise off “cheap” levels. For valuation analysis, we use equity risk premium (ERP), which is the expected return on equities in excess of long-term government bonds. ERP is based on discounted expected cash flows derived from consensus forecasts for dividends and long-term nominal gross domestic product. This is preferable to valuing stocks as a multiple of past earnings, which does not reflect current bond yields or discounted forecasts, making historical comparisons misleading. The ERP on the S&P 500 narrowed from 5 percentage points before the election to 4.25 percentage points in early April. This measure remains higher than its long-term average — 3.5 percentage points — showing that equities are still cheap relative to bonds.
Over the long run, nominal yields on equities and long-duration bonds can be reasonably expected to reflect nominal economic growth. In the US, nominal growth has decreased 3 percentage points over the past 20 years, and bond yields have shrunk in tandem. However, equity yields (ERP plus Treasury yields) have not experienced anything near these declines. Future policies or ERP mean reversion could boost equity valuations, potentially leading the ERP of S&P 500 to trade at, or below, its average.
Investors can respond to the equity rally in two ways. They can side with portfolio investors, who have on average avoided it — 0.1 per cent of net assets have flowed out of US domestic equity funds over the past 12 months, according to ICI, an association of regulated funds. Or they can throw in their lot with chief financial officers — S&P 500 companies’ buybacks in 2016 represented 2.9 per cent of market capitalisation compared with the long-run average of 2.6 per cent, according to Haver.
While we recognise that markets are subject to corrections, we prefer the latter course of action for two reasons.
First, reflationary economic trends favour equities, making them more important if investors are to preserve their capital in real terms. Second, many investors are underexposed to equities and other risk assets. Globally, our private clients hold an average of 25 per cent of their portfolios in cash, rising to 30 per cent for ultra-wealthy individuals. For many investors, the “great rotation” into stocks that was anticipated four years ago has not happened. Although Trump trade is an effective sound bite, it is not an investment thesis. Investors would do well to bear that in mind.
Vinay Pande is head of short-term investment opportunities and Gerald Lucas is a senior strategist at UBS Wealth Management
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