Confidence in the US equity market has been shaken following president Donald Trump’s failure to deliver on key election pledges.
After his victory in November, markets went into overdrive as investors, electrified by pro-growth pledges, poured into US equities. Now reality is biting, as Trump finds implementing policy is more difficult as president than as chief executive of one of his businesses.
This has created short-term market volatility and bouts of indiscriminate selling. However, long-term investors can take comfort that, while Trump’s pro-growth stance was the lightning rod for the recent market rally, the underlying investment case for US equities is the strength of the US economy.
This remains the fundamental reason to invest in US stocks, particularly small and mid-caps, which have a higher domestic exposure.
Investors started growing pessimistic on Trump’s ability to turbocharge markets, as he stumbled badly on a signature campaign pledge to repeal and replace Obamacare.
However, there are grounds for optimism about Trump’s ability to deliver something significant on tax reform. It will take longer than many envisaged and there will be compromises, but a development could provide a stimulus to markets.
The market’s increasing deflation over the Trump trade has also thrown up opportunities. Several companies, on the cusp of making large investments, may sideline activity until the tax picture becomes clearer. This implies risk to earnings in the first quarter and, from a valuation aspect, will create attractive points of entry.
The role of the Federal Reserve (Fed) continues to be crucial. The US still has low rates and progression up the rate curve is expected to be cautious. But the economy is in good shape and there are benefits from the Fed’s flexible, wait-and-see approach.
The basis of Trump’s pledges is not all bluster. Outdated US infrastructure is in dire need of basic maintenance. Another area of opportunity is in rolling back US regulation. This intensified during the Barack Obama era and some moderation is welcome.
It would be sensible to weed out excessive measures that stifle business growth. Banks and financial institutions’ margins suffered under a heightened compliance burden.
Domestic business growth is also a cornerstone in Trump’s jobs manifesto. Following his victory, business optimism spiked massively. A key component was the hope of regulation rollback and tax reform for small businesses. This shows an appetite for resurgence in small business growth and Republicans will be keen to nurture this optimism.
The environment looks favourable for regional banks, due to the anticipated deregulation tailwind, and because banks’ margins should improve as interest rates rise gently.
Under the assumption of a relatively benign economic backdrop, we should see loan growth and an increased margin on those loans. As the optimism in the Trump trade has abated, the opportunity has arisen to top up exposure in regional players.
Trump’s rhetoric is prone to exaggeration and a trillion dollar infrastructure spend may be a stretch, but it seems reasonable to assume a significant increase. Some companies look set to benefit from this stimulus, including areas of the industrials sector such as speciality aggregate businesses.
Bond-like stocks, such as real estate investment trusts and utilities, could come under pressure if, as expected, interest rates rise and create a drag on earnings and test valuations.
The Trump trade, underpinned by tax reform, deregulation, cash repatriation and infrastructure spending, is the icing on the cake for the real US investment case: the robustness of its economy. From a valuation perspective, small and mid-cap stocks offer significant relative value versus large caps and are poised to benefit from Trump’s stimulus initiatives, whatever form they may take.
Mark Sherlock is lead portfolio manager, Hermes Investment Management.