Risk Changes
Risk Changes
With the Trump election concluded, some uncertainty has been removed. However, the actual policy platform remains unclear, with the potential for both a positive outcome for profits through tax cuts but also a more challenging economic backdrop if Trump enacts his tariff and deportation plans.
Interest rates are expected to fall in the US through 2025, but the extent of rate reductions is likely to be much more modest than was expected only a few months ago, as better than expected growth has coincided with stickier inflation. Whilst the Federal Reserve is still expected to cut rates, and in turn provide effective liquidity to asset prices, the inflation uncertainty from the Trump plans may impinge the extent to which investors can rely on the Federal Reserve to drive equities higher.
US profits have continued to outstrip other regions. This has been a major driver of the outsized returns of US equities over the past 16 years. Over the past 10 years, US equities have also been rerated, somewhat justifiably given the delivery of earnings. For the time being the resilience of US profits continues to drive US equities higher, but if the profits backdrop was to falter, equity investors would be left with elevated valuation risk.
Reds in the bed
With the election of Trump and the Republicans gaining a majority across both the Senate and the House of Representatives, the reds have won (in the US the Republicans are the ‘red’ party). In many ways the clean sweep makes it more likely that Trump’s policy plans will be enacted. For US equity investors the attraction of a Trump presidency is centred on the promise of tax cuts.
When Trump cut taxes in his first presidency in 2017, there was a boost to earnings across the US spectrum in 2018. The chart below illustrates the upward bump that the tax change brought about for US profits (EPS: Earnings Per Share).
In 2017 Trump cut corporation tax, resulting in a boost to US profits across the wide size spectrum of US companies
Source: Bloomberg, Artorius
The bump in US corporate profitability, due to the Trump tax cuts, can be seen clearly in the change in growth in 2018 compared to the growth of profits between 2010 and 2017. Across the three S&P indices, the average growth rate of earnings increased by 12 percentage points in 2018, largely (if not entirely) due to the tax change, as shown in the table below.
Source: Bloomberg, Artorius
US equity investors appear to be pricing in a boost to earnings in 2026 (as it will take until the end of 2025 for the legislation to be passed and come into force). Whilst details are yet to be revealed, the outline plan is expected to be more beneficial for smaller and mid-sized companies due to the ‘domestic’ bias of the plans. But, these plans may shift given the characters involved in the Trump campaign, who include leaders of some of the technology giants.
That’s the ‘good news’ for investors. On the flip side, Trump’s proposals for tariffs and deportations are projected to reduce economic growth and raise inflationary pressures. The actual impact is difficult to predict until details of the proposals are revealed and if other countries react with their own retaliatory tariffs.
It is likely that the Trump plans will result in higher government borrowing, as tax cuts - which reduce government revenue – are easier to implement than offsetting cuts to government spending. On the campaign trail, Trump promised $7.8 trillion of tax cuts and only $4.7 trillion of offsets, leaving a proposed deficit increase of $3 trillion.
Together with inflationary pressure from the proposed tariffs, higher government borrowing may result in bond yields remaining higher than would otherwise have been the case. These uncertainties may weigh on investor enthusiasm despite the tailwinds of likely tax cuts.
Flexing interest rates
US inflation is expected to fall further, but recent data suggests that the progress towards the 2% Federal Reserve target may be stalling. Economic data has also been better than expected recently, despite signs of a slowdown in hiring. The risk of inflation remain higher for longer and resilient economic growth has resulted in a shift in interest rate expectations for 2025. In September 2024, investors were expecting interest rates to be cut to below 3% from the then rate of 5.5% during 2025. Now (November 2024), investors expect rates to be cut to ‘only’ 3.75%, from 4.75%.
Since the Federal Reserve stopped raising interest rates in the summer of 2023, the US equity market has climbed 35%. Outside of recessions, when the Federal Reserve has cut interest rates, US equities have tended to rise robustly, underpinning the old adage of ‘never fighting the Fed’.
Interest rate expectations are pricing ‘only’ 0.6% of interest rate reduction in 2025, which is much smaller than the 1.4% expected back in September 2024
Source: Bloomberg, Artorius
Whilst investors expect the Federal Reserve to cut rates in 2025, it is hard not to remain positively disposed towards US equities. The risk is that with heightened inflation risk from the Trump proposals, the Federal Reserve may become more reticent to cut rates in 2025. We remain watchful over the interaction of Trump’s policies with interest rates and the resultant impact on markets.
Profits for the ages
We often write about the US economy and equity market because of its importance in setting the overall investing environment but also due to the fact that the US equity market accounts for over half of the global equity market. It matters, a lot.
The reason for the dominance of US equities is primarily because of the relative growth of profits. US profits have grown (as have revenues) at a much faster rate than other countries. Some would suggest that this is ‘just’ due to the dominance of large technology stocks, but the pattern of outperformance in terms of returns and earnings is also true of the S&P 400, the mid-sized index that sits beneath the large cap S&P 500. It is a truism to suggest that profits drive returns and over the past 16 years US profits have grown more robustly across a wider range of companies than in other regions.
US equities have persistently and consistently outperformed global peers, driven by stronger profits over time
Source: Bloomberg, Artorius
Alongside stronger profits, US equities have become more highly valued than global peers. Until 2015, US equities were similarly valued to the rest of the world, despite having established a track record over the previous 10 years of faster earnings growth. The current backdrop is that investors seem willing to price in faster earnings growth from the US, as the US equity market is now priced at a significant price to earnings premium to the rest of the world.
US equities trade on a much higher valuation to global equities
Source: Bloomberg, Artorius
The key driver for equities over recent years has been earnings (profits). Were the US profits backdrop to falter then the US equity market may underperform global peers, but for the time being profits from US companies continue to be resilient and drive equity markets higher. But the reliance of profits is acute given the elevated valuation risk.
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Conclusion
With the Trump election concluded, some uncertainty has been removed. However, the actual policy platform remains unclear, with the potential for both a positive outcome for profits through tax cuts but also a more challenging economic backdrop if Trump enacts his tariff and deportation plans.
Interest rates are expected to fall in the US through 2025, but the extent of rate reductions is likely to be much more modest than was expected only a few months ago, as better than expected growth has coincided with stickier inflation. Whilst the Federal Reserve is still expected to cut rates, and in turn provide effective liquidity to asset prices, the inflation uncertainty from the Trump plans may impinge the extent to which investors can rely on the Federal Reserve to drive equities higher.
US profits have continued to outstrip other regions. This has been a major driver of the outsized returns of US equities over the past 16 years. Over the past 10 years, US equities have also been rerated, somewhat justifiably given the delivery of earnings. For the time being the resilience of US profits continues to drive US equities higher, but if the profits backdrop was to falter, equity investors would be left with elevated valuation risk.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 22nd November 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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