No Priorities in Tax Plan: Premature Size & Style Rotation

Transcription

1 The Allocator October 2, 17 No Priorities in Tax Plan: Premature Size & Style Rotation David Bianco Chief Investment Strategist, Americas Deutsche Asset Management No priorities in tax plan: Risk of delayed and possibly no corporate tax cut rises The White House tax plan released last week was without details, as expected, but its lack of prioritization was very disappointing. The sweeping outline of business and personal tax cuts only sets the stage for more discord among disorganized Republicans in Congress. We think the most important stimulus President Trump proposes is a corporate tax cut. Yet the longer it s delayed with too broad and complex tax proposals, the more possible it fails entirely on the risk of populist politics as mid-term elections approach. Unlike the market s reaction so far, we re disappointed and now expect no corporate tax cut in 17 and acknowledge a possibility of no significant corporate tax cut in 18. We think any Value rotation led rally this fall will fail. The rotation to Small and Value is likely a false start and raises dip risk this fall Small and Value stocks rallied in recent weeks after gaping YTD underperformance vs. Large and Growth. This rotation assumes a significant corporate tax cut soon to come and that higher interest rates will drive up small Bank profits. The Russell 00 (R2) is weighted more toward Financials than the S&P, and both Small and Financials generate more U.S. profits than the overall S&P, thus R2 should benefit more from a corporate tax cut and higher rates. However, R2 trades at a ~5% price-to-earnings () premium vs. S&P, despite lackluster earnings per share (EPS) growth that lags S&P EPS growth. A corporate tax cut will boost R2 EPS, but even with that benefit it s hard for it to accelerate to the mid-teens pace seen in the last two cycles from its current ~5%. Upon well-spaced U.S. Federal Reserve (Fed) hikes, we think the yield curve flattens some more and limits the benefit to small Banks. We think this rotation to Small / Value is premature and risky with limited upside. Late cycle environments usually favor Growth over Value and Large over Small There is more cyclicality with Small Cap companies. They usually have a strong cyclical bounce in the first several years after recessions. But as more normal economic conditions and trend growth settle in, industries with secular growth usually outperform if valuations are reasonable. Such secular growth is found today within research and development (R&D) driven sectors like Tech and Health Care. In the latter years of the last 3 cycles, Large/Growth outperformed Small/Value. We see no exception for this cycle. We prefer the S&P over R2, and we overweight (OW) Tech, Health Care and just big Banks. We overweight big S&P Banks because we believe 2-3 more Fed hikes are likely through 18 end. Small cap s remain rich vs. large and their history, dependent on acceleration R2 s trailing is.4 excluding all companies with negative EPS. This compares to 19.6 for the full S&P. The relative trailing of R2 vs. S&P is 1.04 now vs average since We think R2 is pricing in a 10-15% corporate tax cut EPS benefit and the S&P nearly 5%. This puts R2 pricing in nearly all the benefit of a 25% corporate tax rate vs. S&P pricing slightly over half. Until there is more clarity and visibility on tax cuts, we stay tilted toward Large over Small. R2 s valuation is also rich on median s. The median of R2 Tech & Health Care ex. negative EPS is 26.3, 15% above its average since. But median for the rest of R2 is.9, 26% above its average. This is partly why we prefer growth over value stocks within small caps. Our near term tactical call for U.S. equities is still Down, but we re bullish longer-term We believe the US expansion will likely continue through 19 with slow growth, contained inflation and just a modest climb in interest rates that occurs mostly at short-end of the curve. Because S&P EPS is likely to be $ this year and ~$140 in 18 even without the benefit of a tax cuts and because persistently low inflation and long-term interest rates are supportive of observed s, we raise our 17 and 18 yearend S&P targets to 2450 and This aligns with the increase in our CIO View 12 month S&P target from 2450 to While we expect a healthy total return from the S&P 500 over the coming year, we think further upside this year from about 2500 is unlikely without more certainty on the corporate tax cut. We think investors are likely to protect this year s 14% YTD total return by selling into any further rally, which will leave the market vulnerable to a quick 5 9% dip this autumn. S&P 500 Outlook S&P Dividend Yield 2.1% 2.1% S&P total return 11.5% 8.2% Next 5%+ price move (Up / Balanced Risk / Down) Risk of near-term correction (Low / Moderate / High) Down Low S&P EPS $119 $131 $140 on trailing EPS DPS $49 $53 Allocations for taxable / USD capital as of October 2, 17 Deutsche AM View Current Long-term Fixed Income 35% 35% Equities 6 55% U.S. Equities 35% 4 S&P % 35% Small Caps (R2) 0- Foreign DM Equities % 15% Foreign EM 5% 0- Alternatives 5% Risk & Duration: Preference shaded Low Risk β Stocks Down Gold TIPS Cash Treasury Bonds Short Duration IG Bonds Muni Yields Up Yields Down Long Duration Bond Substitutes Cyclical Stocks Value Stocks Growth Stocks Defensive Stocks HY Bonds Oil /Copper Stocks Up Source: Deutsche AM. All opinions and claims are based upon data on 10/2/17 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. For illustrative purposes only. High Risk β Contributor - Ju Wang, Investment Strategist & Portfolio Analyst For institutional client and registered representative use only. Not for public viewing or distribution.

2 Growth vs. Value for Russell 1000 and Russell Total Returns Recession 2 years after recession Russell 00 Growth vs. Value Russell 1000 Growth vs. Value Source: Russell, Deutsche AM as of 8/31/17. Past performance may not be indicative of future results. Size (Large vs. Small) vs. Growth (Growth vs. Value) Total Returns Recession Russell 1000 Growth vs. Value (lhs) 2 years after recession Russell 1000 vs. Russell 00 (rhs) Source: Russell, Deutsche AM as of 8/31/17. Past performance may not be indicative of future results. Sector market cap weight of Russell 00 vs. S&P 500 Materials 5% Telecom 1% Real Estate 9% Utilities 4% Cons Disc 12% Cons Staples 3% Energy 2% Real Estate 3% Telecom 2% Materials 3% Utilities 3% Cons. Disc. 12% Cons. Staples 9% Tech 18% Industrials 15% Health Care 14% Financials 18% Russell 00 Tech 23% Industrials Healthcare 14% Energy 6% Financials 15% S&P 500 Source: Russell, Deutsche AM as of 8/31/17. Past performance may not be indicative of future results. For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 2

3 1-year rolling relative return of Russell 1000 vs. Russell % - -% -3 Total Returns 4 3 % - -% Recession 2 years after recession Rolling 1yr relative total return of Russell 1000 vs. Russell 00 Source: Russell, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. 5-year rolling relative return of Russell 1000 vs. Russell 00 % 15% 5% -5% - Total Returns % 15% 5% -5% - -15% % Recession 2 years after recession Rolling 5yr relative total return of Russell 1000 vs. Russell 00 Source: Russell, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. 10-year rolling relative return of Russell 1000 vs. Russell 00 8% Total Returns 6% 4% 2% -2% -4% -6% -8% % 6% 4% 2% -2% -4% -6% -8% Recession 2 years after recession Rolling 10yr relative total return of Russell 1000 vs. Russell 00 Source: Russell, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 3

4 EPS growth of Russell (ex. negatives) and S&P 6 4 Trailing EPS y/y Growth 6 4 % % -% Avg: Russell: 9.3% S&P: 7. -% Recession 2 years following recession Russell 00 (ex. negatives) S&P 500 Source: IBES, Compustat, Deutsche AM as of 8/31/17. Past performance may not be indicative of future results. Trailing of Russell (ex. negatives) vs. S&P Trailing Avg: Russell: 15.5 S&P: Recession 2 years following recession Russell 00 (ex. negatives) S&P 500 Source: IBES, Compustat, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. Relative trailing of Russell (ex. negatives) vs. S&P Recession 2 years following recession Relative Trailing of Russell 00 (ex. negatives) vs. S&P 500 Avg. = 0.96 Source: IBES, Compustat, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 4

5 Dividend yield: Russell 00 vs. S&P Dividend Yield (%) Recession 2 years following recession Russell 00 S&P 500 Source: IBES, Compustat, Deutsche AM as of 9/29/17. Past performance may not be indicative of future results. Median stock trailing of Tech & HC vs. the rest of Russell As of 9/27/17 Tech & HC: 11.0 Rest of Russell: Recession 2 years following recession Median stock trailing of Russell 00 Tech & HC Median = 15.6 Median stock trailing of Russell 00 ex. Tech & HC Median = 14.8 Source: IBES, Compustat, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. Median stock trailing of Tech & HC vs. the rest of Russell 00 (excluding negative EPS) Excluding companies with negative EPS As of 9/27/17: Tech & HC: 26.3 Rest of Russell: Recession 2 years following recession Median stock trailing of Russell 00 Tech & HC Median = 22.9 Median stock trailing of Russell 00 ex. Tech & HC Median = 16.5 Source: IBES, Compustat, Deutsche AM as of 9/27/17. Past performance may not be indicative of future results. For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 5

6 Key Investment Forecasts Economic forecasts 16 17E Interest rates 16 17E Equities 16 17E 18E Global GDP 3.1% 3.7% 2yr Treasury* 1.% 1.85% S&P U.S. GDP 1.6% 2.2% 10yr Treasury* 2.45% 2.6 price return 9.4% 6.1% Capex 0.2% 3-5% 10yr TIPS* % dividend yield 2.1% 2.1% S&P total return estimate 11.5% 8.2% Fed Funds rate* LT IG Muni* 3.35% ~3. DXY Next 5%+ price move: Down Euro* IG Corp* 3.39% 3.5 Oil/bbl (WTI)* HY Corp* 6.46% 6.% Risk of near-term correction: Low Source: Deutsche AM as of 10/2//17. *Forecasts for September 18 Allocations for taxable/u.s. dollar capital as of Oct 2, 17 Deutsche AM View Current Long-term Considerations Fixed Income 35% 35% Expected return/risk Treasury/Agency % seek neg. correlation Municipals > return, < liquid Corp. Credit 5% selective HY > IG Equities 6 55% Expected return/risk U.S. Equities 35% 4 S&P % 35% S&P is global + Tech Small Caps (R2) 0- Beyond beta booster? Foreign DM Equities % 15% Unique? Valuation? Financials 5% 3% OW Foreign Banks Non-Financials 15% 12% OW DM Industrials Foreign EM 5% 0- Alternatives 5% Is it truly uncorrelated? Real Estate/ Private Equity Commodities/FX/Vol/Alpha Tactical adjustments (<6mos): - from equity, + treasury = Down Deutsche AM view: allocations for taxable / USD capital S&P 500 Outlook Dare to ask: 17 end target: 2450 Why not 2800 S&P cycle-high? 2800 = 18x 19E EPS of ~$ end target: 2600 S&P 500 to reach 2800 by 19 end on a long expansionary cycle of moderate growth. 16A 17E 18E S&P avg. trailing 4qtr S&P EPS $119 $131 $ on trailing EPS DPS $46 $49 $ DPS/EPS 38% 37% 38% "S&P stands on the shoulders of bonds" S&P Quarterly EPS: Most favored sectors: 1Q16 $ Q17 $31.00 Healthcare, Tech, Financials 2Q16 $ Q17 $ Q16 $ Q17E $33.00 Least favored sectors: 4Q16 $ Q17E $34.00 Energy, Industrials Source: Deutsche AM as of 10/2/17 Source: Deutsche AM as of 10/2/17 For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 6

7 Deutsche AM S&P 500 Annual EPS Outlook 11A 12A 13A 14A 15A 16A y/y 17E y/y 18E y/y 17E y/y 18E y/y ($) % of 17 S&P 500 EPS (historical constituents) $97.82 $ $ $ $ $ S&P 500 EPS (current constituents) $ $ $ $ $ $ $ % $ % $ % $ % $ % Sector ($ bn) Consumer Discretionary % % % % % % Consumer Staples % % % % % Energy % % % % % % Financials % % % % % % Health Care % % % % Industrials % % % % % % Information Technology % % % Materials % % % % % Real Estate % % % % % Telecommunication Services % % % % % 30 85% Utilities % % % S&P 500 ($ bn) % % % % % % S&P ex. Financials & Real Estate ($bn) % % % % % S&P ex. Energy ($bn) % % % % S&P ex. Tech ($bn) % % % % % % Energy & Financials & Real Est ($bn) % % % % % S&P ex. Energy & Financials/RE ($bn) % % % % % % Source: IBES, Deutsche AM as of 9/29/17. Past performance may not be indicative of future results. * Normalized 17 are mid-cycle normal earnings estimates and the ratios represent normal relative to 17E. Deutsche AM View: S&P 500 fair value by sector: Assuming a ~5.25% real cost of equity (CoE) for overall S&P 500 Market Value ($bn) Current 17 17E Earnings ($bn) Normal Ratio Normal 17E Earnings Accounting Quality Adjustment Fully Adjusted Earnings Real Steady CoE State Value Growth Premium 17 Start Fair Value ($bn) 17E Div idend Yield 17 End 17 End Fair Value Fair ($bn) Value Source: IBES, Deutsche AM as of 9/29/17. Past performance may not be indicative of future results. S&P 500 EPS historical constituents represents the earnings per share (EPS) of S&P 500 index constituents at the time, while S&P 500 EPS current constituents represents the earnings per share of index constituents as of the date the data was compiled 6/30/ end Upside % Consumer 2, % % % 2,196 3% 2, % 2, % Disc. Consumer 1, % ,718 1, % 1, % Staples Energy 1, % % % % 1, % Financials 3, % % ,300 3, % 3, Banks 1, ,508 1, , % Health Care 3, % % 3,057 5% 3,9 1.7% 3, % Industrials 2, % % % 1,958 1, , % Technology 5, % % 4,424 5% 4, % 4, % Materials % % % % Real Estate % % % Telecom % % % Utilities % % % S&P 500 ($ 21, % % % 19,970 2%, % 21,459-1% bn) S&P 500 Index ($/sh) % % % % For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 7

8 Deutsche AM S&P 500 Intrinsic Valuation Model S&P 5 00 Capitalized EPS Valuation S&P Cost of Equity & Fair Book M ultiple Deutsche Asset Mgmt's 17E S&P 500 EPS $ Fair long-term nominal return on S&P 500 index 7.25% Components of estimated fair S&P 500 return: DeAM's "normal 17E" S&P 500 EPS $ Long-term real risk free interest rate 1.25% "Normal 17E" EPS / 17E EPS 101% + Long-term fair S&P 500 equity risk premium* 4.0 = Long-term real S&P 500 cost of equity 5.25% Accounting quality adjustment to pro forma EPS -$ Long-term inflation forecast 2.0 = S&P 500 nominal cost of equity 7.25% Normal 17E S&P 500 EPS fair to capitalize $123 * S&P 500 ERP usually bps, w/ real 5% - 6.5% Key principle: steady-state value = normal EPS / real CoE Fair S&P 500 Market Value and Book Value Multiple S&P 500 EPS Capitalization Valuation 16 end S&P 500 book value per share $800 Normal EPS / (real CoE - (EM/payout) - EM): Fair PB = Fair * normal aggregate ROE 2.92 S&P 500 intrinsic value at 17 start 2333 Fair =(inc ROE-g)/(inc real ROE* (real CoE-real g)) 19.0 S&P 500 intrinsic value at 17 end 2454 Implied S&P 500 fair value of book at 17 start 2333 Implied fair fwd in early 17 on 17E $131 EPS 17.8 Steady-state PB = normal agg. ROE / real CoE 2.92 Implied fair trailing at 17 end on 17E $131 EPS 18.7 Confirmed by fair steady-state = 1 / real CoE 19.0 S&P 500 Dividend Discount Model S&P 500 Long-term EPS & DPS Growth Deutsche AM's 17E S&P 500 DPS $49.00 Deutsche AM's 17E S&P 500 aggregate ROE 16.4% 17E dividend payout ratio 37% 16 end S&P 500 book value per share $800 DB's "normal 17E" S&P 500 DPS $49.00 DeAM's "normal 17E" S&P 500 aggregate ROE 15.3% Normal dividend payout ratio 4 S&P EPS retained for true reinvestment 36% EPS directed to net share repurchases $30.00 Estimated ROE on reinvested S&P EPS 7.25% Normal share repurchase payout ratio 24% Economic margin (EM) or ROE-CoE 0.0 Total payout of S&P 500 EPS $79.00 Sources of long-term earnings growth: Total payout ratio of normal and quality adj. EPS 64% + Long-term inflation forecast Fair return on true reinvestment 1.86% S&P 500 DPS Discount Model + Value added return on true reinvestment 0.0 Normal DPS / (nominal CoE - DPS growth): = Long-term earnings growth 3.86% S&P 500 intrinsic value at 17 start Growth from net share repurchases 1.29% S&P 500 intrinsic value at 17 end 2454 = Long-term S&P 500 EPS/DPS growth 5.15% Implied fair forward yield on 17E DPS of $ Fair normal dividend yield 2. Implied fair trailing yield on 17E DPS of $ = Total long-term return at constant 7.25% Normal EPS / (real CoE-value added EPS growth) 2333 DPS discount model using true DPS (all payout) 2333 Value added growth premium in fair value est. Normal 17E economic profit per share $80.50 S&P 500 EPS discountmodel 5 steps to value: 1) Estimate normalized S&P 500 EPS 2) Adjust normalized EPS for pro forma accounting quality 3) Estimate a fair long term real return on S&P 500 ownership (CoE) 4) Capitalize normalized and accounting quality adj. EPS at real CoE 5) Consider long term potential for value added growth opportunities Normal 16E S&P 500 EPS $125 $130 $ $135 $ % Real cost of 5.25% equity % Source: Deutsche AM as of 10/2/17 Normal 17 earnings per share (EPS) represents an estimate of mid-cycle normal earnings. Equity Risk Premium (ERP) is the expected excess return that investing in the S&P 500 provides over the return from government Treasury bonds. For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 8

9 S&P 500 Sector and Industry views Market Weight (%) Price as of 9/29/17 Source: Deutsche AM Allocated Weight (%) Sector Overweight Equal weight Underweight 17 Ov er-weight 14.9% 18. Financials Banks Insurance Capital Markets Consumer Finance Div ersif ied Financial Serv ices % 18. Health Care Biotechnology Health Care Prov iders & Serv ices Health Care Equipment & Health Care Technology Lif e Sciences Tools & Serv ices Pharmaceuticals % 23. Inf ormation Communications Equipment Electronic Equipment Technology Internet Software & Services IT Services Sof tware Semiconductors Technology Hardware Storage & Peripherals Equal weight 12.4% 12.5% Consumer Internet & Direct Marketing Retail Auto Components Distributors.9.1 Discretionary Multiline Retail Automobiles Div ersif ied Consumer Serv ices Specialty Retail Hotels Restaurants & Leisure Leisure Products Household Durables Media Textiles Apparel & Luxury Goods % 3.5% Utilities Electric Utilities Independent Power Producers Multi-Utilities Water Utilities % 3. Real Estate REITs Real Estate Mgmt. & Development Under-weight 9.2% 8.5% Consumer.7.1 Food & Staples Retailing Bev erages Staples Food Products Household Products Personal Products Tobacco % 6. Industrials Airlines Air Freight & Logistics Aerospace & Def ense Building Products Construction & Engineering Commercial Serv ices & Supplies Electrical Equipment Prof essional Serv ices Industrial Conglomerates Machinery Road & Rail Trading Companies & % 2. Materials Chemicals Construction Materials Containers & Packaging Metals & Mining % 3.5% Energy Energy Equipment & Serv ices Oil Gas & Consumable Fuels % 2. Telecom Div ersif ied Telecommunication Aggregate : Deutsche AM View Ov erweight Equalweight Underweight & 18 EPS & Bottom-up Cons. EPS Bottom-up Cons & 18 Ex Energy Btm-up Cons. Ex Energy For institutional client and registered representative use only. Not for public viewing or distribution. Premature Size & Style Rotation 9

10 Deutsche AM September 18 strategic forecasts Source: Deutsche AM as of 10/2/17. Past performance may not be indicative of future Deutsche Bank AG. All rights reserved. R (10/17) Not for public viewing or distribution. Premature Size & Style Rotation 14

11 Deutsche AM September 18 equity index forecasts Source: Deutsche AM as of 10/2/17. Past performance may not be indicative of future Deutsche Bank AG. All rights reserved. R (10/17) Not for public viewing or distribution. Premature Size & Style Rotation 14

12 Contact Information David Bianco Ju Wang , , Want to start to receive The Allocator and other materials from our thought leaders directly in your inbox? Go to the Subscription Center on deutscheam.com: And sign up and request the types of thought leadership materials you would like to receive by topic (The World, The Markets, and Asset Class Perspectives) or exclusively by one or more of our experts. For purposes of ERISA and the Department of Labor s fiduciary rule, we are relying on the sophisticated fiduciary exception in marketing our services and products through intermediary institutions, and nothing herein is intended as fiduciary or impartial investment advice. Deutsche Bank does not render legal or tax advice, and the information contained in this communication should not be regarded as such. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that we believe to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this date. The underlying assumptions and these views are subject to change without notice. Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Investments come with risk. The value of an investment can fall as well as rise and your capital may be at risk. You might not get back the amount originally invested at any point in time. Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its Deutsche Bank AG. All rights reserved. R (10/17) Not for public viewing or distribution. Premature Size & Style Rotation 14