Week Ending 11.11.2016
• The focus this week was, unsurprisingly, on the wide-ranging economic and investment consequences of Trump’s surprise victory.
• Investment markets have so far given greater weight to the positive aspects of Trump’s policies, such as increased infrastructure spend and tax cuts. The risks over the next few years, however, are equally significant, including increased protectionism and a heightened level of geopolitical uncertainty. These risks appear to have been largely discounted by investors this week and may, in the end, more than counter the positive measures introduced by the new administration.
• What remains to be seen is how many of Trump’s policies will actually be implemented, how some will change and what support they will receive by Congress.
• The AUD has weakened following the US election on the back of USD strength, with risks of further depreciation on Trump’s proposed policies.
The Trump presidential victory merely followed the trend this year of political surprises. While markets were anticipating a continuation of the status quo had Clinton have won, the economic and investment consequences of the outcome are more pronounced. The uncertainy over what will transpire in the next couple of years was reflected in highly volatile market movements as the result become clear. Equities were initially sold off heavily, bonds and gold rallied and the US dollar fell against most major currencies. Each of these trades reversed somewhat soon after Trump’s victory speech, which toned down some of the more extreme rhetoric from his campaign. The focus instead shifted to the positive implications of a more expansionary fiscal policy.
While there is considerable uncertainty over what policies the new administration will ultimately pursue, fiscal stimulus appears to be very much on the table. This is consistent with an emerging theme that fiscal policy is required to take over from monetary policy, which has reached its limits of effectiveness. At this stage, details are light on, however the market has embraced the possibility of a boost to the near-term growth prospects for the US. Higher public spending on the US’s ageing infrastructure is likely to be a priority, with many of the view that the case for increased spend is warranted. Tax cuts are also in the frame, which are expected to target high income earners (which may hence limit the translation into improved demand) and corporates. How much these cuts are saved as opposed to spent in the economy will determine the effectiveness of this policy.
A looser regulatory environment is another likely outcome, a factor which will be viewed positively by equity investors. Trump’s climate change scepticism and wish for US energy independence is a positive for mining and oil companies. The banking and finance sector is also likely to be a beneficiary of relaxed regulations.
What tempers the view is the limited power of the US president. While the chances of legislative change have improved given that the Republican party will control both houses of Congress as well as the Presidency (for at least the next two years), the internal divisions within the party itself may complicate things further. This is particularly true of increased fiscal spending measures that may be at odds with traditional Republican views. Trump may, however, act alone in implementing policies that hurt international trade. Many of Trump’s proposals are also unfunded and thus would diverge from the Republican party’s attempts to reduce the US budget deficit.
While markets have focused on the potential positive outcomes that may result from the election result, the negative risks are equally significant and have much broader global consequences.
Increased protectionism is the principal economic risk to emerge from Trump’s victory, particularly given that this was a central plank of his campaign, extending an anti-globalisation trend that has been in place for some time. Trump’s policies included the withdrawal of the (yet to be ratified) Trans-Pacific Partnership, renegotiating the North American Free Trade Agreement and measures to impose tariffs on Mexican and Chinese imports, two of the three biggest trading partners of the US. The risk from trade policy is higher given the ability of the US president to introduce tariffs without congressional approval. A global trade war, while perhaps unlikely, is at the extreme end of risks resulting from these policies, which would reduce global trade and economic growth, reduce consumer spending and stoke inflation.
US Trade (% of Total)
Increased geopolitical uncertainty is also likely to weigh heavily on markets during Trump’s presidency. A deterioration in relations between the US and its allies is a possibility, particularly given Trump’s speculation of a withdrawal from NATO and a view that the US’s allies should fund more of their own security. Trump’s views are also in conflict with existing and long-standing US foreign policy in many regions around the world.
A wide range of long-standing institutions have come under attack from Trump, however among the most important to financial markets is the Fed. The president-elect was critical of the central bank in the election campaign, noting the ineffectiveness of low interest rates which have created a “false economy” and not translated into real growth. The possibility of greater political oversight of the Fed’s monetary policy decisions and a breakdown in its independence is real. At the very least, change in the composition of the Fed’s board is likely over the next 18 months as vacancies arise, although notably chair Janet Yellen’s term runs until February 2018. A more hawkish Fed may hence result, which would increase the chances of the US slipping into a recession.
Trump’s proposed policies are widely regarded to result in a higher level of inflation. Reduced trade, the introduction of tariffs, increased fiscal spend in the US and tighter immigration policy all point towards inflationary pressure in the medium term. Fiscal stimulus in a US economy that is approaching full employment would, in all likelihood, also translate into wages growth and inflation.
For these reasons, this week’s events have led to a sell-off in bonds, pushing yields higher. Markets still widely expect that the Federal Reserve will hike rates for a second time next month and the consensus is for a further two hikes in 2017. However, the risk is now that a faster pace of rate rises will occur over the next few years. The path that the Fed takes may largely depend on how comfortable it will be should inflation race ahead of its 2% target.
The likely effects of the US election are generally negative for Europe and much of the rest of the world, notwithstanding the spill over effect of potentially stronger US economic growth. Following the populist and anti-establishment results of Brexit and the US election, political contagion risks are heightened, with Italy’s impending referendum (on December 4) and upcoming elections in Netherlands (March), France (April) and Germany (September). These are events that could potentially cause a reassessment of each country’s place in the EU, which would be damaging for the region.
Weaker global trade would hurt economic growth in many regions, while commodity-driven inflation would be unhelpful. Export-focused emerging markets with large structural current account deficits have among the most to lose from this scenario, particularly if the US dollar strengthens further. Economies that are more consumer driven will be insulated to a degree. China is moving in this direction, however exports are still a large of its GDP equation. With Trump labelling China a ‘currency manipulator’ and threatening tariffs on imports, the flow on risks to Australian commodity demand are evident.
From an investment point of view, the more bullish commentators have pointed towards renewed strength in the US equity market. Some caution, however, is warranted. Equity valuations and profit margins are already high, policy detail of the new administration is still largely uncertain and it may take time for this to translate into an improved earnings environment. The higher wages that Trump has promised many US workers would also inevitably eat into corporate margins. A lift in inflation coupled with a lack of economic growth would also be a negative for valuations.
What is more certain is that the gap between the winners and losers from a sector perspective could be quite significant. Multinational companies that rely on global trade would be at risk from Trump’s protectionist policies. Financials would face an improved environment with a steeper yield curve and looser regulations. Miners and energy could also benefit from a more benign regulatory environment, while increased infrastructure spend would lift underlying commodity demand. Healthcare is in limbo, with the repeal of Obamacare likely, although it is unknown what its replacement will be. Successfully implemented fiscal stimulus would result in the outperformance of the more cyclical, growth-orientated sectors of the market.
Finally, downside risks to the AUD have risen this week following the election. Expansionary fiscal policy with simultaneous tighter monetary policy points towards a stronger USD in the medium term. A shift in global trade policy towards greater protectionism is also negative for the Asian region and Australia. It is likely that the RBA will see how these factors develop over the next six months, although the uncertainty of this week has raised the probability of a further rate cut. This would see the RBA follow the Reserve Bank of New Zealand, which cut its own cash rate by a further 25bp this week, its seventh such cut in the current cycle.
Fixed Income Update
• Global bond yields were volatile following Trump’s victory in the US election.
• Term deposit rates fell in September and October, but demand remains strong.
The bond market was not immune to the high levels of volatility experienced across financial markets in the wake of the US election result. Immediately following the outcome, the bond market rallied, with participants buying up safe haven assets (government bonds from developed countries) and selling equities. However, Trump’s acceptance speech of increased fiscal spending put inflation well and truly back on the table, reversing previous gains as bond yields lifted and prices fell.
Inflationary expectations affects the long end of yield curves and while US fiscal spending will take a while to be implemented, it is therefore not surprising that the larger moves were felt on 10 and 30 year bonds. A similar yield change has a much larger price impact on longer-dated bonds.
The effect of the US election moved the Australian bond market more to the downside than other offshore markets, as previous gains (when the result was evident) were corrected and Australian Commonwealth Government Bonds (ACGBs) followed US treasuries down. The price movement on bank bills and 3 year bonds was fairly muted given their short maturity and yields were capped as they remain anchored to interest rate settings by the RBA. Ten and 30 year yields have been the most volatile, with the latter which is the inaugural 30 year ACGB that was issued a month ago) falling 6% from its high, putting it down a net 4% over 24 hours. The higher volatility as tenor lengthens is evident in the chart below.
US Election Impact on the Price of ACGBs
While fixed rate bonds have been volatile (and may continue to be so for some time,) prices on floating rate credit bonds have barely moved. Credit spreads widened slightly, then retracted, with investment grade indices in the US and Australia (US and Aust iTraxx) back at the same levels prior to election day. There has been strong demand for US credit from Asian clients following the election, with Japanese and Taiwanese life insurance companies buying 10 and 30 year credit bonds. Credit spreads may therefore continue their tightening trajectory, aiding performance for fixed income credit.
Following the rate cut by the RBA in August, the major banks were actively marketing their term deposits, enticing investors into term deposits of 1 year and longer, whilst reducing short-term rates in line with the lower RBA interest rate. However, these attractive levels were short-lived, with all banks reducing medium term rates by October, as illustrated in the following chart.
Term Deposit Rates
Despite interest rates being at historically low levels and spreads to the swaps curve tight, demand for term deposits has not withered. According to data from the Australian Bureau of Statistics released near the end of October, annualised growth in deposits was 8.9% in September, the highest it has been since 2012.
• Westpac’s (WBC) full year result came in line with expectations, with flat earnings growth and an unchanged dividend, reflective of the difficult banking reporting season.
• DuluxGroup (DLX) delivered a solid result, although faces some challenges in the year ahead with a slowing housing market and the closure of Master’s.
• The US election has had wide-ranging implications for our domestic equity market.
Westpac (WBC) rounded out the banking reporting season this week with a result that was in-line with expectations. Reflective of the fairly challenging environment facing the sector, cash earnings were flat year-on-year, while earnings per share fell 5% following the bank’s capital raising 12 months ago. The fears of some investors of a dividend cut were not realised, with WBC instead deciding to keep its final dividend steady. With a dividend payout ratio of 80% in the year (or 72% after taking into account the effect of investor participation in WBC’s dividend reinvestment plan), the sustainability of its dividend will continue to hang over the stock into FY17.
Westpac’s results were not too dissimilar to the trends that were evident across the banking sector (see following table). Revenue growth was in the low single-digit range. Net interest margins were largely unchanged over the year, although were weaker in the second half. Despite a focus on realising ‘productivity’ benefits over the last three years, costs expanded at 3%, the same pace as the top line, leaving the bank’s cost to income ratio flat.
Impairment charges were the primary swing factor among the major banks. Westpac’s 17bp for the year was a step up from the ultra-low level of FY15, however improved in the second half, with an absence of the large single-name exposures of the first half. Benign bad debts were a feature of the second half of the financial year across the sector. While there is little evidence to suggest a breakout that would impair earnings significantly in coming years, a gradual normalisation could still have the effect of restricting earnings growth in this time and, subsequently, dividends.
FY16 Banking Scorecard (Underlying Cash Earnings Basis)
Westpac also cut its medium term return on equity target of 15% in a sign that returns in the banking sector are now structurally lower. Increased regulatory capital is the primary reason for this shift, however lower margins, lower fee income and the decline in interest rates have also played their part. The bank’s new target range is 13-14%. With a 14% return in FY16, this suggests that WBC is implying that returns are still at the upper end of its target. The derating of the banks on the key measures of P/E and price/book should be viewed in this context; historical pre-GFC valuations are no longer as relevant.
Westpac: Return on Equity
Commonwealth Bank’s (CBA) reporting period is out of cycle with the other majors, however the company still provides a limited trading update in these quarters. The bank’s cash earnings were flat year-on-year and the highlight again was a bad debts charge of just 18bp. Costs were relatively well contained, leading to some margin expansion in the period. While CBA is still viewed as the highest quality of four majors, converging returns across the sector could eventually result in pressure on its P/E premium to its competitors.
Several factors lead to the view of a cautious approach to the sector. These include the possibility of bad debts trending higher, costs rising at a similar pace to revenues, margin pressure from competition and some lingering risk of higher capital requirements at some point in the near future. The short term counter to this is the relatively attractive dividend yields on offer, particularly as many high-yield stocks and sectors are exposed to capital risk in a rising interest rate environment, a factor which has re-emerged this week. In our new concentrated model portfolios, we have positions in Westpac and ANZ, although remain underweight the sector.
DuluxGroup (DLX) also reported another result that continued its history of generating relatively predictable earnings growth. The company’s profit was up by 5% over the 12 months, which was again driven by 7% growth in its core paints division. Other divisions were more mixed, with a flat result in its consumer and construction products business, while weak margins impacted its garage doors division.
DLX has certainly benefited from the robust conditions in Australia’s housing market over the last few years, however less so compared to other building products suppliers given a much greater reliance on the renovations market as opposed to new housing. Nonetheless, a tapering housing market coupled with likely stock liquidation from the closing Master’s stores (in which DLX has a low representation) pose somewhat of a challenge for the next 12 months. Despite a relatively low growth outlook, the stock trades on a forward P/E of approximately 18X.
The Australian equity market is expected to have its own groups of winners and losers as a result of the outcome of the US election:
- Trump’s inflationary fiscal policies have lifted bond yields in the US as well as domestically. This has turned into a headwind for the wide range of ‘bond-proxies’ in the Australian market (infrastructure, utilities, REITs and Telstra), which had already come under pressure in recent months. Conversely, stocks on the other side of this trade, particularly QBE and Computershare, stand to benefit from higher investment earnings.
- Yield curve steepening is a positive for our banking sector, as this has contributed to margin pressure over the last few years.
- Proposed infrastructure spend has given a further boost to the mining sector, which has already staged a significant recovery since early this year.
- If the US dollar were to strengthen further then this would be positive for the large number of stocks with overseas earnings. This tailwind has subsided over through most of this year, but several leaders in the industrials sector would receive an earnings lift. The counter to this could be slower trade and/or economic growth from other regions of the world.