Quotidian Investments Monthly Commentary – February 2017
One month into Donald Trump’s tenure and a clearer picture of the man and his methods is emerging. Unlike generations of politicians before him, his determination to fulfil his pre-election promises is already apparent and his actions so far are having a palpable positive effect on the US economy and its stockmarkets.
We mentioned in our January report the beneficial effect of lower taxation (both corporate and personal), less regulation and the creation of more jobs; Trump has made positive progress in each of these areas. In particular, corporate taxes take a huge bite out of a company’s cash flow and profits. Trump has committed to lowering corporate tax rates and creating incentives which will encourage companies to keep their operations in the US and to hire US citizens (who, of course, would also be US personal taxpayers).
As a result, companies are now more likely to reinvesttheir tax savings in order to grow their businesses. This would allow them to take on more (and better-trained) employees, improve their infrastructure and technology use and capture greater market share.
During Trump’s first day of actual work as President he met with representatives of many of the largest companies in the USA. At that meeting he emphasised that he would cut business regulations by 75%. Freed from the burden of more and more complicated compliance regulations (and the ever increasing numbers of non-productive staff needed to cope with them) this is a huge boost to American business. Even if he ultimately ends up cutting existing business regulations by only 30% that would still provide businesses with the capital to hire more productive workers, to expand growth and thus to generate greater profits for shareholders.
In particular, at a meeting with the CEO’s and senior executives of major companies in the biotech and pharmaceutical sector (following an initial plea for lower drug pricing which was mere rhetoric and window-dressing) he confirmed that he was reducing the enormous burden of regulation that had been increasing imposed by his predecessor and that had become a constipation to research and development as well as to profits.
New medicines and drugs will now achieve FDA approval much more quickly and thus generate cash-flow and profits to the conceiving company in a much shorter timescale. Whereas in the past it could have taken, in extremis, as long as 13 years for a new drug to be approved, that approval process is now expected to be no longer than 4 years. The impact on share valuations in this sector has been dramatic and the dark cloud hanging over it under the last 18 months or so of Obama and Hilary Clinton’s inept stewardship has cleared.
Since Trump was elected last November the Dow Jones Index has risen by over 10%and held above the technically significant 20,000 level whilst the S&P500, the Nasdaq and the Russell 2000 index (which measures Small-Cap stocks) have also reached all-time highs. This has demonstrably been a very broadly based uplift in US equity markets.
Now that he is established in office and by judging his actions thus far simply from an economic perspective, we believe we are on the cusp of a period of economic growth in the United States that hasn’t been seen in decades. And as a direct consequence of that, as the USA economy expands then there will be a beneficial knock-on effect to the global economy.
Aside from the economic reasoning outlined earlier in this report, our optimism is based on one market statistic that has been a fundamental factor behind the US stockmarket’s move higher and that factor is the yield on 10-year US Treasury bonds. This yield rate has an influence on returns across the entire global financial market not just in the USA.
At the start of 2017 the 10-year US Treasury yield stood at 2.45% and despite the uplift in US equity valuations it has barely moved since. This means that current 10-year US Treasury buyers (of which there are few) are exchanging their investment capital for an annual yield of just 2.45% and the return of their original investment ten years from now with no hope for growth in either the coupon payment or the original capital investment (no more, no less) being returned at the end of their 10-year holding period. We have often described investment in Treasuries (or gilts in the UK) as return free risk and this is a perfect example to illustrate that point.
Now if we compare the 10-year Treasury return to the S&P500. With the dividend yield on the S&P500 hovering around 2%, investors committing their capital to that benchmark US stock index will receive a regular dividend payment of about 2% annually and, more importantly, the prospect of future growth on both that dividend payment as well as their capital investment. Growth in the dividend payments as well as potential appreciation on the capital invested is a powerful combination.
Growth (in the equity environment) versus No Growth (in the bond environment). No wonder that long-term investors are increasingly choosing to opt for growth and that is what is driving stock prices higher.
Even if interest rates are, as expected, pushed marginally higher by the Federal Reserve during 2017 it will only affect the short-end of the yield curve and not the 10-year rate.
With this scenario unlikely to change in the foreseeable future we are of the strategic view that we stay in stocks and shares until the 10-year bond yield moves higher. If and when that 10-year bond yield noticeably changes then we will change our minds.
Of course, equity markets cannot and will not continue upwards at their recent breakneck pace and so we expect to see a typical stock market correction (to allow share prices to draw breath before moving higher again); that eventuality will be a buying opportunity rather than a panic to the exit doors.