The major US stock indices and the film La La Land both broke records this month. The S&P 500, Dow Jones and Nasdaq hit all-time highs and La La Land won seven Golden Globe awards. But the question for investors is whether US equities are now in La La Land.
The Positives. Let us round up the reasons to be cheerful under three headings. First, animal spirits. President-elect Donald Trump has given US corporate morale the feel-good factor without actually doing much. However, importantly, he has nominated a business-friendly senior team. Ray Dalio of Bridgwater reckons that the key eight personnel have just 55 years’ experience of public office (mostly in the military) but 83 years in business. The equivalent figures for Barack Obama were 117 and five(!) respectively.
Second, fiscal stimulus. While artfully avoiding specific numbers, Trump has promised lower taxes and more infrastructure spending, which will give the economy a budget boost. We should get a sense of how big next month when the White House delivers its draft budget to Congress.
Third, micro measures. Mr Trump has dangled a raft of measures before the public and the markets. His proposals include a corporate tax rate cut from 35% to 15%, reducing the personal income tax bands from seven to three, a bonfire of regulations and a shake-up of energy policy. These plans could be partly paid for by getting rid of tax breaks and widening the tax base and also by a one-off 10% repatriation tax on firms’ overseas earnings.
The Negatives. However, there are also reasons to be gloomy. Here are a few:
The pre-election reasons for caution – a sluggish economy and expensive valuations – are still there. This economic recovery has been lacklustre at best. And, while equity valuation is an imprecise art, the chart shows that both the forward price/earnings and price-to-book ratios are around cyclical highs.
Furthermore, President Trump is not guaranteed to get his agenda through Congress. Trump has been talking in terms of tax cuts and spending increases but Congress prefers fiscally neutral programmes.
Also, part of the Trump package is trade barriers and immigration curbs. These were popular on the campaign trail but may not be good for either the economy or the corporate sector.
Even if Donald Trump does deliver a sizable fiscal lift, it may result in more inflation rather than more growth as the economy over-heats. And the latest FOMC minutes openly suggest that rising inflation would be offset by faster interest rate increases.
And, finally, a policy mix of easier fiscal but tighter monetary policy is a recipe for a stronger US dollar. The dollar has risen by a manageable 5% over the past six months but further appreciation will put downward pressure on corporate earnings.
Conclusion. We think the best explanation of the post-election rally is the prospect of corporate tax cuts. There is a fair chance that Donald Trump will push this initiative and that it will get through Congress. The result may be higher after-tax earnings for years ahead which discount to higher equity prices now.
However, all the good news may now be in the price and the markets could be entering La La Land. Could Inauguration Day on Friday be the start of the next downturn?
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