Red Sweep
Red Sweep
US Companies are starting to update their shareholders with quarterly reports. How companies guide analysts is normally instrumental to how the results are received. Where companies are upbeat, then investors have been willing to drive equities higher.
However near-term events in the US, with a poor showing from Biden at the Presidential debate and the attempted assassination of Trump, has boosted Trump’s chances of becoming US president in November. This has resulted in a focus on potential policies from a Trump administration. Tax cuts, a clamp down on immigration and imposition of tariffs are all policies that garner populist support in the US.
Economically these policies are likely to result in higher inflation but also a rise in the budget deficit. This may push up bond yields. For equity investors, the prospect of corporation tax cuts to 15% is being received well especially for US small and medium sized companies. Back in 2017-18 when tax cuts were enacted by the Trump presidency, small and medium sized companies saw their profits increase by more than larger companies in the US.
In the meantime, the US economy shows signs of slowing. With lower inflation, the Federal Reserve is increasingly likely to cut interest rates in the coming months. The rise in unemployment is not yet consistent with a recession, but any fiscal stimulus of a Trump program may deliver an elongation to the economic cycle in the next few years.
The Reds are coming
Up to the attempted assassination on 13th July, Donald Trump had been the narrow favourite to win the US presidential election. The shooting appears to have cemented Trump as the likely winner in the November election.
Trump is likely to inherit an economy that has outperformed other developed economies and low inflation. Whilst there are signs that the US labour market is slowing, this is yet to tip into a recession scenario. But with lower inflation, it is likely that the Federal Reserve will cut interest rates if the labour market slows further.
Whilst there are scant details over Trump’s policy proposals, a trend towards ‘national’ conservatism’ appears to be proposed by the Republican party, which is at odds with its historical tilt towards free trade and free market capitalism. The suggested policy of a 10% tariff on all foreign made goods indicates that the Trump presidency will reignite trade tensions with China and Europe. Most commentary around the Trump tariff threat has focused on the impact on US inflation, but if introduced, trade tariffs would also have negative consequences for non-US economies.
In a replay of the tax cuts in his first presidency, Trump is proposing additional tax cuts. These tax cuts will in effect make permanent the 2017 tax cuts that were scheduled to expire in 2025. Trump also proposes to cut corporation tax from 21% to 15%.
Without spending cuts, which seem to be anathema to the populist Trump, fiscal budget deficits and government debt are likely to climb. The benign backdrop of falling inflation for the bond market seen for much of 2024, may become more fraught if bond yields rise to compensate investors for inflation risk and the need to attract additional investors to fund higher budget deficits that appear likely under the Trump plans.
For equity investors, the proposed corporation tax cuts may result in a boost to profits which may aid the earnings outlook. In addition, the Trump agenda appears to be willing to reduce regulation especially when it comes to environmental issues. On the margin, this is likely to be a tailwind for US companies, albeit not necessarily planet earth.
Democrat supporters appear to be turning towards the Senate election as a way to nullify some of the potential impact of Trump. If the Democrats can control the Senate, then they will have some power over policy. 33 of the 100 U.S. Senate seats will be contested in regular elections this November, along with a special election in Nebraska. Republicans are considered to have a fundamental advantage, as Democrats are defending 23 of the 33 seats. Among these, three are in states that Donald Trump won in both the 2016 and 2020 elections, suggesting that a motivated Republican voter base could lead to Republican victories.
As such it is likely that the Republicans could hold power across the Presidency, the Senate and House of Representatives. This ‘Red Sweep’ would make enactment of the Trump manifesto more likely.
Whilst the path to lower US interest rates seems clear ahead of the election, investors may have to rethink their expectations of lower rates through 2025, if the Republicans take control of the Presidency and Congress (both the House and Senate).
Earnings in focus
Each quarter, US companies report quarterly revenue and profits (earnings). As we enter the reporting season, we wait to see the evolution of guidance. Companies have typically exceeded analysts’ expectations in announcing their results but have tended to reduce expectations for subsequent periods. The sceptics amongst us may suggest that companies reduce expectations to ensure that the hurdle is lower for future delivery.
There is a continued gap in profits delivery between the S&P 500 (the index that tracks the largest 500 US companies) and everything else. S&P 500 profits (as tracked by the earnings per share index (EPS)) appear resilient despite the moderating economic backdrop. This has chiefly been driven by the technology giants. A side note is that this may face greater scrutiny post-election whoever wins.
S&P 500 earnings per share (EPS) continue to rise, and support the equity market
Source: Bloomberg, Artorius
US mid-cap (tracked by the S&P 400) continue to see profit expectations decline for 2024 and 2025. There is a natural upward bias to the 12 month forward EPS number, which hides the degree to which analysts are changing the forecasts through a particular year. The downgrades in expectations to earnings for 2024 and 2025 for the S&P 400 (mid-caps in the US) are in contrast with the upgrades to the S&P 500 earnings’ estimates.
Earnings (EPS) of mid-sized US companies have been more modest than the large cap peers, and estimates for 2024 continue to drift lower
Source: Bloomberg, Artorius
This loops back to the prospect of the Trump presidency. In 2017, Trump cut corporation tax. This led to a significant rise in analysts’ expectations for profits through 2017 and 2018. As analysts factored in the tax cutting measures (only agreed in late 2017), the estimates for 2018 rose quite markedly across all sizes of companies, but especially for smaller companies (as reflected in the S&P 600)
The 2017 tax cuts benefitted small and mid sized companies more than the larger S&P 500 companies
Source: Bloomberg, Artorius
US versus the World
The difference in profits appear to be a key driver of the relative performance of US equity compared to the rest of the world. In 2022, US profits fell relative to the rest of the world, and the US equity market underperformed. Since the start of 2023, US profits have been stronger than other regions, and this has contributed to US equities outperforming.
The relative performance of US equities compared to the rest of the world seems to have been driven by the pattern of profits.
Source: Bloomberg, Artorius
Trump’s plan appears to be a potential boon for US companies. The long lived US outperformance may continue but the type of US companies that do well may shift towards smaller and mid-sized companies that have historically benefited the most from tax cuts.
Economic cycle still to negotiate
Whilst the prospects for profits in a Trump presidency appears to have triggered a sharp short-term jump for smaller and mid-sized equities, the economic cycle rumbles on. The Federal Reserve is likely to cut interest rates in September, as inflation has been better than expected but also due to evidence of a slowing economy. This is showing up in rising unemployment.
If the Federal Reserve cuts interest rates and the Trump presidency leads to tax cuts, the long awaited recession may be delayed once more, and investors may have to adjust their risk appetite. That said, the Federal Reserve may want to hold off too many interest rate cuts in the face of fiscal profligacy, but that looks like it is a 2025 question.
Lucky generals… lucky Prime Minister
The incoming UK Labour government is facing a public sector that appears to have suffered neglect. Prison overcrowding, NHS waiting lists, sewage in rivers, potholes etc. appear to be symptomatic of the lack of good governance in the UK. Whilst the problems may take time to solve, the Labour government do appear to have been handed a better economy than could have been hoped for only a few months ago.
One way that the better than expected data is measured is by the CITI economic surprise indicator. When data comes in stronger than expected, as has been the case of late in the UK then the indicator moves above 0, and when data is poor, as has been the case in the US, the indicator falls below 0.
The better-than-expected backdrop (at least in the short-run) should result in a better fiscal backdrop as tax revenues should pick up alongside the economy. That said, it is likely that the UK government may resort to additional fiscal measures to increase tax revenue. Of particular interest (and potential concern) for our clients, are potential changes to inheritance tax and capital gains tax.
The UK economic data has come in better than expected in recent months, even whilst the US has weakened
Source: Bloomberg, Artorius
A boon for the consumer? Lower inflation but high wage inflation is resulting in a sharp rise in real incomes in the UK
Source: Bloomberg, Artorius
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Conclusion
US Companies are starting to update their shareholders with quarterly reports. How companies guide analysts is normally instrumental to how the results are received. Where companies are upbeat, then investors have been willing to drive equities higher.
However near-term events in the US, with a poor showing from Biden at the Presidential debate and the attempted assassination of Trump, has boosted Trump’s chances of becoming US president in November. This has resulted in a focus on potential policies from a Trump administration. Tax cuts, a clamp down on immigration and imposition of tariffs are all policies that garner populist support in the US.
Economically these policies are likely to result in higher inflation but also a rise in the budget deficit. This may push up bond yields. For equity investors, the prospect of a corporation tax cut to 15% is being received well especially for US small and medium sized companies. Back in 2017-18 when tax cuts were enacted by the Trump presidency, small and medium sized companies saw their profits increase by more than the larger US companies.
In the meantime, the US economy shows signs of slowing. With lower inflation, the Federal Reserve is increasingly likely to cut interest rates in the coming months. The rise in unemployment is not yet consistent with a recession, but any fiscal stimulus of a Trump program may deliver an elongation to the economic cycle in the next few years.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 19th July 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
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