Since the election in November 2016, the outlook for US equities has changed dramatically and US small caps in particular have the potential to benefit should the ‘Make America Great Again’ batch of government policies promulgated by Donald Trump actually be implemented. While as investors, we are always faced with making decisions with less than perfect information, we have determined what we believe to be the most likely policy agenda of the incoming Trump administration, what central scenario appears to be priced into financial markets already – and thus where opportunities may lie.
There remains a broad sense that President-elect Donald Trump and a Republican-dominated Congress will focus on pro-growth initiatives. While the equity market has rallied and is clearly discounting the positives from such an agenda, details are still fluid. All of this makes handicapping what actually might happen extremely challenging. Investors appear reassured by Trump’s mostly traditional political appointees, but the initial euphoria has faded. They are now looking for specifics about tax reform policies, the future of the healthcare system and how spending priorities will be sequenced.
A shot in the arm for the US economyIn our view, a pro-growth package would include: • A reduction in the top corporate tax rate to 20% • A significant reduction in corporate regulation • Repatriation of off-shore corporate profits at a lower tax rate on a go-forward basis (i.e. not just a temporary tax holiday) • A significant infrastructure investment programme, possibly funded by the initial burst of corporate revenues brought home under the repatriation plan • Lower income tax rates
What could the republican agenda mean for US small-cap investors?
The post credit crisis world has been one of slow US GDP growth and a reflation of stock prices. Stocks have been buoyed by easy monetary policy leading to historically low interest rates. We believe we may now be entering a new phase of growth. Not a continuation of the tired cycle, but the start of a new cycle fuelled by fiscal stimulus.
We expect rising revenues, a pickup in inflation and rising business confidence to result in an acceleration in earnings growth. Earnings growth is finally poised to accelerate heading into 2017 due to easy comparisons, fiscal stimulus and the potential of more favourable tax policies. Smaller companies should also benefit from increasing risk appetite among investors. Furthermore, small caps tend to have greater operating leverage due to weaker economies of scale. Given their greater domestic orientation, their earnings should hold up better as the US dollar rises.
Exhibit 1: Revenue source by region for US listed companies: smaller companies (represented by the Russell 2000 equity index) are more exposed to domestic economic trends and earn less revenue in the EMEA and APAC regions (in %)
Source: FactSet as of 30 September 2016
We expect mergers and acquisitions (M&A) to remain an important theme in assessing the outlook for small-cap stocks. 2016 was a cycle high for small-cap M&A action as reflected in both deal count and deal value involving companies in the Russell 2000 index. Although fiscal stimulus and/or tax cuts could steer companies away from ‘buying’ growth, we think the opportunity to acquire technology, customer sets, capabilities or earnings accretion will continue to be a strong motivator.
Small-cap sectors: identifying the winners
Stocks with a high domestic exposure are likely to do better than globally active companies given the concerns over a proclaimed Trump trade policy, and this should benefit smaller stocks. In addition, small-cap stocks have a stronger correlation to US GDP growth: if this rises (as we suspect it will), small caps would benefit. Our market view is focused on economic sensitivity. Sector-wise, industrials (infrastructure) would be helped given their cyclical nature and they also stand to benefit from being domestically focused. Financials have rallied post-election due to the market expectation that a Trump government will be less onerous on regulation and that the Federal Reserve might tread a steeper path when it comes raising policy rates as growth and inflation accelerate.
Income tax cuts could help boost spending and that may help consumer stocks. As for information technology, it is our belief that these companies could get a boost from the repatriation of cash as we will see more M&A (from an already all-time high) in this sector. Companies could also use the cash to buy back stock and pay dividends, which can help stock market performance. Finally, healthcare stocks look well positioned to outperform, particularly in the biotechnology and pharmaceuticals industries. These stocks have significantly lagged the market in the wake of Hillary Clinton’s campaign talk of price controls and we would expect this group to perform strongly. Healthcare stocks rallied immediately after the election, but that rally stalled as investors awaited specific policy proposals.
It will be a stockpickers' market
Finally, we see a return of idiosyncratic factors driving stocks, which should lead to higher performance dispersion. We believe we are looking at an environment that will be much more favourable for stock picking. In general, we think market leadership is becoming more dynamic. This suggests that investment selectivity is growing in importance, which is an implicit argument for active management.
---Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.
See also: With Trump’s promised policies, the USD is already becoming “Great Again” by Adnan Akant, PhD, Head of Currencies at FFTW