NEW THINKING The Trump Tailwinds Bruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee March 2017
The Trump Tailwinds In February 2015, the TD Wealth Asset Allocation Committee (WAAC, we) moved to a neutral position in U.S. equities, believing that tailwinds were dissipating. Between then and the U.S. election in November, the S&P 500 index generated a price return of approximately 5% (just under 3% annualized) and a total return of approximately 8% (just under 5% annualized). Both of these were in line with our expectations for low- to midsingle digit returns. However, our outlook and positioning have changed: immediately following the election, WAAC upgraded U.S. equities as we believe they are poised to outperform their global peers. A number of President Trump s proposed policies could stimulate economic growth and inflation, including his plans to lower taxes, reduce regulatory burdens and invest heavily in infrastructure. Lower taxes and deregulation may also stimulate corporate earnings growth. We are conscious of the tug-of-war between these expansionary policies, which should be beneficial for the economy and corporations, and the administration s protectionist trade rhetoric, which could be harmful to the economy and corporations if implemented into policy. However, based on a belief that the positives outweigh the negatives over our 12-18 month outlook horizon, we prefer an overweight position. U.S. on an upswing We pay close attention to economic growth because there has been a strong correlation between it and corporate earnings growth, and our examination reveals that a number of the new administration s policies have the potential to increase U.S. economic growth. For example, proposed tax changes are likely to provide a boost. Currently, 44% of personal income tax filers don t pay taxes. Under the new rules, this would jump to 63%, 1 and those who do pay taxes will see reductions that should allow them to retain approximately 10% more after-tax money. 2 This bodes well for consumer spending and aggregate demand. Corporations can also expect meaningful reductions in the amount of tax they pay, which would leave them with more cash for investment. Accelerating consumer spending, increasing aggregate demand and higher corporate investment should all spur economic growth. This is good news for equity investors as the largest driver of corporate earnings is economic growth and, historically, rising economic growth has been positive for equities. Earnings set to receive a policy push In addition to improved economic growth, we anticipate that a number of Trump policies may afford companies opportunities to increase their earnings. This is a key factor in our decision to favour U.S. equities as there is a strong link between corporate earnings growth and equity returns. While central bank actions have certainly helped to support equity market growth over the past several years, earnings have also been a key driver. The graph below shows that there has been a clear correlation between the S&P 500 s performance and the earnings growth performance of its component companies. 2 THE TRUMP TAILWINDS
We believe one of the most important contributors to improved earnings growth will be the new administration s proposed corporate tax changes. Our analysis concludes that for every 1% reduction in the effective corporate tax rate there is usually a corresponding 1.5% to 1.75% increase in earnings. Currently, the corporate tax rate is 35% and the effective tax rate for S&P 500 companies is in the range of 27-29%. Estimates for the new corporate tax rate range between 20% and 25%, which will represent significant savings that will enhance corporate bottom lines. Another change that we believe will provide a meaningful benefit is decreased regulation. Quantifying this is difficult, but to provide context, in 1950, 5% of the workforce was licensed; this has risen more recently to 30%. 3 Increased regulation results in higher training costs, higher consumer costs and creates barriers to employment. Two sectors that stand to benefit greatly from less regulation are Energy and Financials, but we believe deregulation will have a positive impact on a broad range of industries. For example, Richard Fisher, former President and CEO of the Federal Reserve Bank of Dallas, tells the story of a Texas-based entrepreneur who owns eight dry-cleaning stores. He hasn t expanded beyond that number because the regulatory environment is too onerous he already employs a compliance officer to ensure that regulations are adhered to. Adding more stores would simply add to the regulatory burden his business faces. If there was less regulation in his industry, he would have more incentive to expand his business. Overall, we expect deregulation could drive growth. Figure 1: S&P 500 Index Performance vs. S&P 500 Earnings Per Share Growth December 31, 2009 December 31, 2016 2500 140 120 S&P 500 Index Level 2000 1500 1000 500 Earnings Per Share S&P Index Level 100 80 60 40 20 S&P 500 Earnings Per Share 0 09 10 10 10 11 11 11 12 12 12 13 13 13 14 14 14 15 15 15 16 16 16 0 Source: Bloomberg Finance L.P., TD Asset Management 3
Earnings Outlook Earnings per share growth comprises 5 main elements: sales, earnings before interest and taxes (EBIT), interest, taxes, and shares outstanding. When we look at how these are likely to perform in aggregate over the next 12-18 months, our outlook is for positive earnings growth. Accordingly, we project that U.S. equities may provide mid- to high-single digit returns. Contributors to S&P 500 Company Earnings Component Sales Observations Sales, which are the biggest component of earnings, tend to grow in line with nominal GDP. As we expect GDP growth to improve, we expect correspondingly positive earnings growth. Forecasted Contribution to Earnings Ç EBIT Companies have already significantly reduced their costs over the past several years, and margins are close to record highs. In addition, wages are growing, which is likely to offset some of the gains made through sales. Interest Companies benefitted greatly as interest rates steadily declined, thus reducing their cost of borrowing. If interest rates rise as new policies spur economic growth and inflation, this would be a headwind. È Taxes President Trump's proposed corporate tax cuts would add meaningfully to companies' earnings. Ç Shares Outstanding Earnings per Share Companies have been buying back shares from cash flow, and this trend may well continue, particularly if offshore profits are repatriated to the U.S., which would provide a small boost to earnings. Sum of all the above Ç small positive Ç 4 THE TRUMP TAILWINDS
With the S&P 500 Index rising 74% (price return) over the 5 years to January 31, 2017, many are wondering if stocks are overpriced. It s true that valuations are stretched, and the significant multiple expansion that has been an important tailwind for markets in recent years is likely behind us. However, while valuations may contract somewhat, this should be offset by solid earnings growth. We are mindful though that there is a possibility for a short-term pullback in the market as some of the benefits of the proposed new policies have already been factored into asset prices, but they will be implemented in political time, not market time. Legislation can be a lengthy process, and there is potential for disappointment among market participants if policies are not implemented as swiftly as investors anticipate. Figure 2 below shows our forecast for the S&P 500 Index. Figure 2: Potential Price S&P 500 Index 3000 2500 2000 S&P 500 Actual Price TDAM Potential Model (current) TDAM Potential Model (Trump)* Forecast Index Level 1500 1000 500 0 93 95 97 99 01 03 05 07 09 11 13 15 17 19 *Assumes a reduction in corporate taxes and a 50 basis point acceleration in GDP. Source: TD Asset Management, Bloomberg Finance L.P., As of December 12, 2016 Potential Pitfalls We are more optimistic about the outlook for U.S. equities than we were prior to the election. Of course, there are still risks. Chief among these are President Trump s protectionist sentiments after all, there are very few historical examples of countries that have isolated themselves into prosperity. If he takes extreme measures, global trade would suffer and restrain global growth. In addition, trade wars with China and Mexico could ensue, resulting in higher consumer costs, which would be a headwind for the U.S. economy. Affected countries might also devalue their currencies to offset the impact of any additional tariffs imposed by the U.S. If China were to devalue the yuan, most of south east Asia would likely follow suit in order to remain competitive, which would create a deflationary environment in North America. 5
Another area of concern is that consumers may save rather than spend any extra money that results from personal tax cuts. Similarly, companies may opt to save the proceeds of their tax cuts rather than use them for productive investment. Both of these scenarios would present a headwind for economic growth. It likely goes without saying, but President Trump s unpredictable nature is also a risk and could fuel shortterm volatility. Finally, there is uncertainty about how some of the new administration s policies will be funded, and they could have a significant detrimental effect on the national debt over the longer term. However, WAAC s outlook horizon is 12-18 months, and we believe that during this timeframe, U.S. equities will outperform other global equities. Continental Divide: A more conservative forecast for Canada While Canada may feel some positive spillover effects from higher economic growth in the U.S., which is our largest trading partner, we believe the Canadian economy is likely to remain lacklustre, with modest positive economic growth and low inflation. According to Bank of Canada (BoC) calculations, there is still slack in our economy and it won t return to full capacity until mid-2018. BoC officials also anticipate that inflation will remain low hovering just below 2% for both 2017 and 2018. Weak growth and inflation will make it more challenging for Canadian companies to grow their earnings versus their U.S. counterparts. There is also well-founded concern over potential changes to terms of trade with the U.S. as President Trump plans to renegotiate NAFTA. Although his primary concerns are with Mexico, Canada s economy and businesses could be negatively affected if trade conditions become less favourable, particularly given that approximately 75% of our exports go to the U.S. In terms of equities, the S&P/TSX had a strong year in 2016 as oil and commodity prices picked up significantly, which aided returns. However, that tailwind is unlikely to be repeated this year, and our expectation is that Canadian returns will be more muted and will underperform U.S. equities. The S&P/TSX index is much narrower than its U.S. counterpart, and its fate largely turns on the outcomes in its three key sectors: Energy, Materials and Financials. We anticipate each of these will have positive performance but to lag their notable 2016 gains. Demand for oil is strong, but inventories are still elevated, and while OPEC has agreed to reduce production, President Trump s policies are likely to bring more shale oil online. We expect oil to trade in a range of approximately $50-60, which is a viable level for Canadian producers and certainly improves their earnings outlook, but is not high enough to make capital spending attractive. Globally, growth momentum appears to be building slowly and infrastructure spending is increasing, both of which should be supportive of commodity prices, and the price increases witnessed in 2016 will be helpful for Materials company earnings. However, commodity prices are vulnerable to slowing economic growth in emerging markets, which is possible given their high debts levels and the potential for a rising U.S. dollar. Within the Financials sector, companies with U.S. operations will likely benefit from reflation, tax cuts and higher interest rates there, which should be positive for their earnings. Broadly, Canadian companies are less likely to benefit from the same Trump-related tailwinds that are likely to lift U.S. equities, and the tailwinds they enjoyed last year are receding. Based on this outlook, our expectation is for Canadian equities to provide low-single digit returns, so we are maintaining our neutral weighting. 6 THE TRUMP TAILWINDS
Our view In light of the potential for higher economic and earnings growth, we are overweight U.S. equities and expect them to provide mid- to high-single digit returns. While equity returns are likely to be lower than those investors enjoyed as markets recovered from post-crisis lows, we believe equities remain a vital component of portfolios as they can help to preserve the real value of capital in this low yield world. It s important to note that equities do come with a higher risk profile than bonds. To mitigate this risk, a portfolio should ideally contain three key elements: an emphasis on risk management that ensures risk taking is being properly compensated; a high level of diversification to help mitigate the impact of market movements; and a focus on quality companies with strong balance sheets, high returns on capital and consistent cash flows. This disciplined approach should help investors navigate challenges that may arise. About the author Bruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee @BruceCooper_TD About TD Asset Management TD Asset Management (TDAM), a member of TD Bank Group, is a North American investment management firm. Operating through TD Asset Management Inc. in Canada and TDAM USA Inc. in the U.S., TDAM brings new thinking to investors most important challenges. TDAM offers investment solutions to corporations, pension funds, endowments, foundations and individual investors. Additionally, TDAM manages assets on behalf of almost 2 million retail investors and offers a broadly diversified suite of investment solutions including mutual funds, professionally managed portfolios and corporate class funds. Collectively, TDAM manages over C$287.9 billion in assets as at December 31, 2016. 7
Unless otherwise stated, all market statistics sourced from Bloomberg Finance L.P. 1 Tax Policy Institute, Urban Institute and The Brookings Institution 2 Tax Foundation 3 The Brookings Institution The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual s objectives and risk tolerance. Certain statements in this document may contain forward-looking statements ( FLS ) that are predictive in nature and may include words such as expects, anticipates, intends, believes, estimates and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. Index returns are shown for comparative purposes only. Indexes are unmanaged and their returns do not include any sales charges or fees as such costs would lower performance. It is not possible to invest directly in an index. The TD Wealth Asset Allocation Committee ( WAAC ) is comprised of a diverse group of TD investment professionals. The WAAC s mandate is to issue quarterly market outlooks which provide its concise view of the upcoming market situation for the next six to eighteen months. The WAAC s guidance is not a guarantee of future results and actual market events may differ materially from those set out expressly or by implication in the WAAC s quarterly market outlook. The WAAC market outlook is not a substitute for investment advice. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. TWITTER, TWEET, RETWEET and the Twitter logo are trademarks of Twitter, Inc. or its affiliates. All trademarks are the property of their respective owners. The TD logo and other trademarks are the property of The Toronto-Dominion Bank. (0317)