STORY TIME!

Donald Trump’s victory is providing all kinds of financial experts with unexpected material to imagine new, more bullish economic and financial scenarios. Just in time, because the fables of 2015-16 were getting pretty stale. Judging by a stock market unable to find any inspiration to convincingly break 2100 during 22 months, the boring movie was putting equity investors to sleep while making the fortunes of their fixed income counterparts.

Just when most everybody were finally coming to accept that America was no longer capable of growing at 3.0% plus, a Donald-in-the-Box springs out of seemingly dormant Rural USA and proclaims that he will make America great again. Nobody gave much credibility to the candidate, but when he unexpectedly morphed into a President-elect, heck, there’s gotta be something serious in this character!

Even more so since the real estate mogul actually took control of the whole neighborhood: he and his family will occupy the White House, his stunned prodigal friends will control the main House while other “colleagues” will very narrowly rule the guest House.

And the control freak will top it all with radical changes at the Supreme Court, making America conservative again.

It is rather easy to build strong, seemingly credible growth narratives with Mr. Trump firmly in charge. After all, this President is a businessman, a billionaire, a doer as many like to say. And he surely will waste no time, wanting everything done by tomorrow.

He had wasted little time detailing his economic policies during the long campaign, but everybody nonetheless seems to know enough to conclude that The Donald will pull it off, against all odds, once more.

The building blocks are there before every eyes to see and believe:

• Cut personal and corporate taxes to quickly boost demand and repatriate foreign cash stashes.

• Invest massively in the country’s infrastructure to quickly boost growth.

• Repeal, or perhaps rather modify Obamacare to quickly cut corporate costs.

• Dump Dodd-Frank to quickly allow banks to lend again.

Voilà! That should be enough to quickly add up to 2.0% to GDP.

According to Michael Feroli at J.P. Morgan, the full adoption of the Trump campaign package would involve tax cuts (mainly on households at the upper end of the income scale, and on corporations) worth $500bn per annum along with extra infrastructure and defence spending equal to about $150bn a year.

The Keynesian multiplier applied to the tax cuts may not be much more than 0.7 for households and 0.2 for corporations, but infrastructure spending may have a multiplier of 1.0 or more, so the entire programme could add about 2 per cent to the level of US GDP by 2018. This implies about 1 per cent per annum on the growth rate. (Gavyn Davies)

Meanwhile, the Trump magic could also quickly repeal NAFTA, TTIP, TPP, even NATO, slam duties on Chinese goods, boot millions of illegal immigrants out and block entry to new ones, return the Fed to the back pages and, eventually, renew discussions on the size of the federal debt…Whether or not these would impact the economy seem to be matters for remote considerations, or eventually another chapter

Holman W. Jenkins, Jr. summarized the mainstream bullish narrative in the WSJ:

Mr. Trump was already repositioning himself to be the growth president well before his surprise triumph on Election Day.

By virtue of being elected, he ends various Obama regulatory wars against major sections of the U.S. economy. That can only be bullish. A tax reform, along traditionally idealistic GOP lines with lower rates and fewer loopholes, can only be bullish.

(…) if we can get 2% growth with the tax code and regulatory policies we now have, 3% ought to be within reach if we get better policies. (…)

CLSA banking analyst Mike Mayo pronounced this week’s election the end, finally, of the 2008 financial crisis. He meant an end to the punitive actions against business that, as we should have learned in the seminal 1930s, only prolong the pain. (…)

Even though only 14% of economists polled by the WSJ before the elections said his economic policies would spur growth, the bullish scenario has been reproduced, more or less verbatim, by numerous economic and financial commentators since November 9. And equity markets responded patriotically. 

That is without considering trivial matters such as earnings, inflation and interest rates. The story is good enough, no need to waste precious time on valuation even though that was a nearly universal worry barely 2 weeks ago.

When equities are richly valued like they are now, 3 conditions can keep them rising:

1. strong and sustainable earnings growth;
2. declining inflation rates;
3. and/or some positive spin that will keep animal spirits alive and boost sentiment so that basic fundamentals can be pushed aside, for a while.

Earnings seem to have stopped declining in Q3’16 and their outlook is brightening somewhat, which fits well into the new story. Trailing earnings are finally rising after nearly 18 months of a soft decline since their mid-2015 peak. According to Factset, S&P 500 EPS rose 2.9% in Q3 (+4.1% per Thomson Reuters) and are seen up 3.6% in Q4 (+6.4% per TR). If so, trailing EPS will rise from their current $117.29 to around $118.00 when Q4’16 results are all in by next March. This would be a 3.5% gain from the mid-2016 trough.

Significantly, Factset calculates that EPS ex-Energy rose a strong 6.2% in Q3 with revenues up an also strong 4.5%. Corporate America’s ability to grow earnings even in fairly windy conditions is amazing.

Inflation is more problematic as recent inflation data around the world have turned upwards. But most storytellers don’t mind incorporating some price acceleration in their scenario. After all, this is what all central bank doctors have been ordering for years and it can only help the earnings part of the story, assuming the higher inflation rate impacts revenues more so than costs…

Inflation expectations jumped to nearly 2% right after the elections, up markedly from their mid-year trough of 1.4%. Actual inflation will need to be closely monitored as accelerating economic (demand) growth without accelerating inflation may be wishful thinking.

The Rule of 20 has proven very adept at incorporating the impact of inflation on equity market multiples. A jump from 2.0% to 3.0% inflation decreases fair equity value by 5.5%. If the earnings effect fails to match the inflation effect, equities will need something else to keep going along the story script. 

But these valuation details (earnings and inflation) have been totally omitted in most of the recent “growth is back” stories as investors seem more than happy to get swiftly teleported to this new Trump universe.

Some caveats are in order before getting too far, too quickly:

• William McGurn in the WSJ:

When Dwight D. Eisenhower was elected in 1952, Harry Truman opined that his successor would quickly learn that a general has more power than a president. “Poor Ike,” said Truman. “When he was a general, he gave an order and it was carried out. Now he’s going to sit in that big office and he’ll give an order and not a damn thing is going to happen.”

(…) Though Mr. Trump has never commanded armies, as a business leader he presides over a corporate structure whose clear chain of command is more like the military’s than either are to the presidency.

• The Economist:

The hope is that this election will prove cathartic. Perhaps, in office, Mr Trump will be pragmatic and magnanimous—as he was in his acceptance speech. Perhaps he will be King Donald, a figurehead and tweeter-in-chief who presides over an executive vice-president and a cabinet of competent, reasonable people. When he decides against building a wall against Mexico after all or concludes that a trade war with China is not a wise idea, his voters may not mind too much—because they only expected him to make them feel proud and to put conservative justices in the Supreme Court. Indeed, you can just about imagine a future in which extra infrastructure spending, combined with deregulation, tax cuts, a stronger dollar and the repatriation of corporate profits, boosts the American economy for long enough to pacify the anger. This more emollient Trump might even model himself on Ronald Reagan, a conservative hero who was mocked and underestimated, too.

Nothing would make us happier than to see Mr Trump succeed in this way. But whereas Reagan was an optimist, Mr Trump rails against the loss of an imagined past. We are deeply sceptical that he will make a good president—because of his policies, his temperament and the demands of political office.

(…) After the sugar rush, populist policies eventually collapse under their own contradictions. Mr Trump has pledged to scrap the hated Obamacare. But that threatens to deprive over 20m hard-up Americans of health insurance. His tax cuts would chiefly benefit the rich and they would be financed by deficits that would increase debt-to-GDP by 25 percentage points by 2026. Even if he does not actually deport illegal immigrants, he will foment the divisive politics of race. Mr Trump has demanded trade concessions from China, Mexico and Canada on threat of tariffs and the scrapping of the North American Free Trade Agreement. His protectionism would further impoverish poor Americans, who gain more as consumers from cheap imports than they would as producers from suppressed competition. If he caused a trade war, the fragile global economy could tip into a recession. With interest rates near zero, policymakers would struggle to respond. (…)

The second reason to be wary is temperament. During the campaign Mr Trump was narcissistic, thin-skinned and ill-disciplined. (…) If Mr Trump fails to master his resentments, his presidency will soon become bogged down in a morass of petty conflicts.

The third reason to be wary is the demands of office. No problem comes to the president unless it is fiendishly complicated. Yet Mr Trump has shown no evidence that he has the mastery of detail or sustained concentration that the Oval Office demands. He could delegate (as Reagan famously did), but his campaign team depended to an unusual degree on his family and on political misfits. He has thrived on the idea that his experience in business will make him a master negotiator in politics. Yet if a deal falls apart there is always another skyscraper to buy or another golf course to build; by contrast, a failure to agree with Vladimir Putin about Russia’s actions leaves nobody to turn to. Nowhere will judgment and experience be more exposed than over the control of America’s nuclear arsenal—which, in a crisis, falls to him and him alone. (…)

More specifically:

• On corporate tax rates:

Deutsche Bank estimates that the U.S. corporate tax rate will be cut to about 25% to bring it in line with the OECD average. DB calculates that every 5 percentage point cut lifts the earnings per share of S&P 500 companies by a cumulative $5.00. This straight line math is faulty because too simplistic and not mindful of the reality:

It’s a rock-solid fact that the U.S. corporate statutory tax rate is the highest among developed nations and is significantly higher than the average. According to 2014 data from the OECD, the combined federal and state statutory corporate tax rate for the United States is 39.1 percent. The average of the other 33 members of the OECD is 24.8 percent — 14.3 percentage points lower than the U.S. rate. Weighted by country GDP, the average for these 33 countries is 28.3 percent — 10.8 percentage points lower than the U.S. rate.

There is, however, an unsettled debate over whether and by how much the U.S. corporate effective tax rate is higher than effective tax rates outside the United States. Effective tax rates seek to measure how much businesses really pay after all deductions and credits are considered. (…) 

On average, the foreign effective tax rate is not much lower than the U.S. domestic tax rate. (Forbes)

In March 2016, the Government Accountability Office published a report for the U.S. Senate Committee on the Budget and concluded:

For tax years 2008 to 2012, profitable large U.S. corporations paid, on average, U.S. federal income taxes amounting to about 14 percent of the pretax net income that they reported in their financial statements (for those entities included in their tax returns).

1. Companies don’t have to pay the full U.S. rate on foreign profits they earn and leave overseas. The more they can book profits in low-tax countries, the lower a rate they pay. That’s partly achieved by companies’ real operations in growing markets around the world and partly achieved by profit-shifting maneuvers that load up deductions in the U.S. and income overseas.
2. Companies can get targeted tax breaks for everything from domestic manufacturing to corporate research to investing in low-income housing.
3. Congress and President Barack Obama have been offering special tax breaks to try to encourage companies to invest as the U.S. was recovering from the latest recession, including accelerated write-offs of equipment purchases. (WSJ)

The fact is that because of all the tax wrinkles, loopholes and corporate structuring, the overall U.S. effective tax rate is really not uncompetitive, at least for corporations which can and do use all possibilities available through the complex tax code.

The U.S. Treasury produced a report with this table last April revealing the effective actual tax rate by industry between 2007 and 2011:

The NYU Stern School of Business is kind enough to share this much larger and more up-to-date data set. Professor Damodaran produced a table that aggregates more than 2100 companies for a quick glance at the tax gaps between industries. Hint: the lower the actual tax rate, the most likely it will rise after an eventual reform, and vice-versa…

There will be winners, but there will also be losers, possibly big losers. FYI, the S&P 500 weight of the 8 industries with a tax rate of 20.5% or less in the table above totals 58%, raising the possibility that aggregate S&P 500 EPS and/or prices could in fact be negatively impacted by a major corporate tax reform. These sectors are also those with the higher P/Es, currently based on low-taxed profits.

• Trump’s Infrastructure Plan Faces Speed Bumps

The president-elect’s infrastructure plan largely boils down to a tax break in the hopes of luring capital to projects. He wants investors to put money into projects in exchange for tax credits totaling 82% of the equity amount. His plan anticipates that lost tax revenue would be recouped through new income-tax revenue from construction workers and business-tax revenue from contractors, making the proposal essentially cost-free to the government. (…)

Experts and industry officials, though, say there are limits to how much can be done with private financing. Because privately funded projects need to turn a profit, they are better suited for major projects such as toll roads, airports or water systems and less appropriate for routine maintenance, such as repaving a public street, they say.

Officials also doubt that the nation’s aging infrastructure can be updated without a significant infusion of public dollars.

(…) tolls have proved unpopular in much of the country, with toll-road operators in Indiana and Texas filing for bankruptcy protection in recent years.

“The real need is straight up funding, not additional financing tools,” said Bud Wright,executive director of the American Association of State Highway and Transportation Officials. (…)

It’s also unclear how Mr. Trump’s proposal would generate enough new revenue to offset the cost of the tax credits. If the construction workers hired on the new projects were previously unemployed, the proposal would indeed generate significant new tax revenue. But with the unemployment rate for construction workers around 5.7%, it is likely those workers would have found other jobs and paid income tax regardless. (…)

One trillion dollars over 10 years is not all that stimulative. Obama’s 2009 $830 billion over 10 years did not do any wonders for the economy, did it? On the other hand, the Trump magic would bring debt/GDP from 85% to 105% which, given that interest rates will likely rise along with faster growth, would take the debt servicing ratio from 7% of revenues to nearly 25% in 10 years. Republican congressmen have strong principles and many will likely balk at many Trump proposals. Also, their slim majority in the Senate could hinder the speed and depth of their implementations.

• On Dodd-Frank:

Mr. Trump said he is eager to focus on the 2010 Dodd-Frank financial-overhaul law, which he called “a tremendous burden to the banks.” He said: “We have to get rid of it or make it smaller.… Banks are unable to lend. It’s made our country noncompetitive. It’s slowed down growth.” (…)

“The people who are really good, but need money to open a business or expand a business, can’t borrow money from the banks.” (…) (WSJ)

But banks have been lending:

And loan availability to small biz is not bad at all as recent NFIB surveys reveal:

• On trade:

(…) “Whether they go forward depends on whether we can return to balanced trade, and whether they add to GDP growth,” Mr DiMicco said. “The era of trade deficits is over. It will be: let’s talk, but otherwise we put tariffs on.” (…)

The Peterson Institute for International Economics (PIIE), a think-tank, has estimated the impact of Mr Trump’s trade policies under three scenarios, ranging from “aborted trade war”, in which Mr Trump is forced to lower tariffs within a year of imposing them, to a “full trade war” with Mexico and China. In the former case, global supply chains are disrupted and 1.3m private-sector American jobs are lost; in the latter, the damage includes the loss of 4.8m American jobs and would spill over into the services sector, too. Adam Posen of the PIIE says Mr Trump’s trade policies would be “horribly destructive”. (The piecemaker | The Economist )

Mr. Trump said he would preserve American jobs by imposing tariffs on products of U.S. companies that relocate overseas, thereby reducing the incentive to move plants abroad. That would also reduce these companies’ competitiveness. Hopefully, the President will wake up to the realities of manufacturing and global competition.

In effect, what Mr. Trump said then is different than what is he saying now as the economic and political reality of actual power are setting in. The bulls are banking on the prospect of a significant toning down of most of Trump’s campaign growth killers on immigration and trade. Maybe he is also realizing the necessity to get his facts right.

But whether we get Trump lite or not, Mr. Market will also need to get its facts right and face some harsh realities:

• While Democrat-turned-Republican Mr.Trump has yet to display any strong economic ideology, old-time Republicans truly believe in smaller government and fiscal discipline. Spend and borrow has not been a strong mantra among Paul Ryan’s troops and Tea Partyers. This is a GOP-controlled House and Senate, far from being Trump-controlled.
• Tax reform does not happen overnight. It took Reagan more than 4 years to get it trough. Also, globalization has made corporate tax matters a lot more complex than in the 1980s.
• Trump is no Ronald Reagan by any stretch of the imagination. The art of the business deal is very different than the art of the political deal.
• Trump’s tax proposal is not significant for the middle class and would raise inequalities further. Top earners are not where the marginal spending would come from.
• Trump’s trade policies would directly hurt the lower and middle class through higher import tariffs and fewer manufacturing jobs. Just as the U.S. killed the TPP, 16 Asian countries (33% of world GDP and half the world’s population) formed the Regional Comprehensive Economic Partnership. The White House Council of Economic Advisers estimates that with reference to Japan alone, this trade agreement will negatively impact 35 U.S. industries and 162,000 companies currently doing business with Japan. “Nearly 5 million people work in U.S. goods-exporting industries that could face a direct loss of competitive position relative to China if RCEP were to give its member countries preferential access to the Japanese market over U.S. firms.”
• Infrastructure spending is a slow train to get moving as President Obama learned in 2009 when he was in full control. Furthermore, fiscal multipliers are lower in highly indebted economies.

And then we have the bond vigilantes in full swing already blowing strong headwinds on the $150 trillion world-wide fixed income market on the “bullish story”:

• Rising interest rates are not bullish on highly indebted America where nonfinancial obligations total 251% of GDP (135% when Reagan was first elected). MacroMavens estimates there are $2 trillion of U.S. corporate debt coming due during the next 2 years.
• Rising mortgage rates are not bullish on housing.
• Rising interest rates are not bullish on vehicle sales.
• A strong dollar is not bullish on exports and domestic companies competing against foreign goods and services.
• Trumponomics have suddenly inflated interest rates across the globe, most of which will barely feel any economic boost therefrom but will immediately share the pain from rising interest and capital repayments. Want it or not, the USA is not an isolated island oblivious to what’s happening abroad. Emerging markets are vulnerable to a strongly appreciating dollar. There are about $10 trillion in foreign borrowing in USD that eventually needs to be repaid.

So while equity investors currently only focus on an eventual and possibly elusive growth rebirth and the media enthusiastically fit the narratives with the trends, it is best to remain cool and rational and first assess current market valuations before seeing if a particular narrative could really boost profits and/or P/Es in any significant way.

As said, trailing EPS on the S&P 500 Index are on the rise again and are now $117.29 per Thomson Reuters. Based on current Q4’16 estimates (+4.9%), full year earnings are poised to reach $118 when the Q4 earnings season is complete by mid-March 2017.

The market’s P/E is thus 18.8x trailing earnings (18.6 after Q4) and the Rule of 20 P/E is 20.9 (20.7 after Q4). Both measures are on the high side, where prospective returns are below average.

The more dependable Rule of 20 (even more so currently given the renewed inflation risks) also warns against being too hasty:

 

  

When Obama was elected in 2008, also on a mandate to change things (“Yes we can!”) and a large infrastructure spending program, P/Es were 15.5 and the Rule of 20 P/E was 16.6, both fairly reasonable levels. Yet, with earnings still dropping and inflation turning into deflation, equities retreated another 25%, taking P/Es and the Rule of 20 P/E down to 11.7 and 11.8 respectively by February 2009.

When Reagan was elected in 1980, the market P/E was 9.5, but on its way to 7.6 a year later as interest rates kept climbing. The more significant Rule of 20 P/E was a dangerous 22.2 in November 1980, on its way to an attractive 14 almost 2 years later when the bull market started, but only after equities lost another 25%.

In both cases, equities devalued even though both elections marked a significant change from the previous leadership and inspired hope and bullish stories for many.

Fundamentals generally trump stories.

The Reagan years were characterized by generally flat earnings for 6 years while the Volcker Fed was reigning inflation down from 13% to 1%. The net result on the Rule of 20 scale was to gradually lift the Rule of 20 Fair Value (yellow line on the chart) from 110 in November 1980 to 300 by October 1986 as inflation dropped. The S&P 500 Index followed the improving fundamentals and rose from 140 to 244.

Either we buy this new story, however expensive equities may be, with all the ifs, as and whens that come with this new maverick President, or we remain patient waiting for more attractive valuations and a story that is based on solid facts, not on flaky possibilities wrapped within an attractive and captivating story.

Once again, equity investing is a game of probabilities. At the present time, the odds don’t look friendly, not only from a valuation standpoint but also from a quality of the story viewpoint. Narratives can change quickly as we learned after 9-11 and after Obama’s infrastructure plan, just to use two tales from the same collection.

Personally, I am too old to invest based on fairy tales, having heard them all. I remain prudent, stable income minded and very choosy on equities.

For good measure, let’s look at the stories on some of the trendiest sectors in this so-called Trump era:

• U.S. banks’ post-election rally may be just an appetizer

The U.S. banking sector’s dramatic rally post Election Day is likely just a taste of bigger gains to come, as investors expect banks to reap huge benefits from rising interest rates and lighter regulation under a Donald Trump presidency. (…)

“They are not close to being expensive yet,” said Peter Kenny, senior market strategist at Global Markets Advisory Group in New York.

The S&P 500 banks are currently trading at about 11.2 times forward earnings estimates as a group, up from about nine times in February, when the index hit its lowest since May 2013.

Valuation is still well off peak levels of over 33 times earnings estimates in May of 2009, though it trades near levels seen between 2002 and 2008, before many current regulations were put in place.

If rates continue to rise and the Trump administration gives some clarity on how regulations will change, then bank valuations “certainly can move higher,” Piper Jaffray analyst Kevin Baker said. (…)

Valuations for too-big-to-fail designated banks are at around 12.5 times forward earnings compared with multiples of 13 to 15 for banks outside of this category, according to Baker. (…)

This CPMS/Morningstar chart plots trailing EPS and P/Es on U.S. bank stocks since 1994. Excluding the unrepresentative 2008-2011 period, P/Es have been fairly consistent between 15 and 19 times trailing EPS. Even during the sharply accelerating profit period of 2001 and 2003, P/Es remained within the channel, actually declining to the lower end of the range late in 2002.

So, if bank stocks are “not close to being expensive yet”, it must be on another metric. Price-to-book values have just jumped to the high end of the 2007-2016 range of 1.5-2.0x. One can hope that we are about to re-live the 1995-2005 period when P/B ratios fluctuated between 2.0 and 2.5 times but that needs to assume that ROEs are also on their way back to the 15% area, a huge step up from their recent 9.5% level.

Bank profits must rise more than 50% to reach previous ROE levels. Time will tell if they can grow that fast under a potentially deregulating environment but the large U.S. banks must continue to abide by international standards. Capital requirements have been lifted meaningfully after Lehman, placing a serious lid on ROE capabilities.

• Industrials

Industrial stocks are another trumpy sector on the notion that infrastructure spending, trade measures and tax reform will combine to boost margins and earnings in coming years. This is a highly diversified sector which generally benefits from faster economic growth…when not accompanied by a surging dollar which, in the last 3 instances has materially impacted profit margins. Also, the Treasury table shown earlier suggests that industrial companies are not suffering from a particularly high effective tax rate. The story here has many chapters, some of which also have many different endings. Unfortunately, we don’t get to choose the actual ending.

Stories often carry more complexities than some authors want us to believe…