Emma Wall: Hello, and welcome to the Morningstar series, "Market Reaction." I'm Emma Wall and I'm joined today by Rathbones Strategist, Ed Smith, to discuss the Trump rally.
Hello, Ed.
Edward Smith: Hello, Emma.
Wall: So, it's been two months since Trump won the U.S. election and one month since he became the 45th President of the United States. What do we know so far?
Smith: Well, I don't think we know very much more than we did on November the 08th or November the 09th. A lot of talk about corporate tax reform, is there going to be a Board of Tax, is there going to be interest deductibility ended, we just don't know. Lots of talk about fiscal stimulus, again, is this infrastructure package ever going to get through, we just don't know. And yet, the markets seem to be acting as though we do know.
Those sectors most sensitive to uncertainty that you would expect to do badly when uncertainty rises have been beating the market. Those sectors that are most geared into the business cycle that do well when the economy reflates have been beating the market. So, clearly, a lot of investors think that we do know a lot of good stuff; we're not so sure.
Wall: Is it as simple as the fact that the record highs, both in the U.K. and the U.S. presumably because of Trump, do companies believe in his growth strategy? Do they believe he will be able to get 4% U.S. GDP growth?
Smith: Potentially. Although, we have noticed that some companies, particularly in the U.K., have started to issue a little more cautious guidance. So, we're not sure about companies. But if you look at some of the surveys in the real economy, consumer confidence in the U.S. or the NFIB survey of small businesses, a lot of those have popped right back to top of the business cycle highs, particularly the small business survey measure of is it a good time to expand. Between November and December that registered the biggest jump we've ever seen since the survey began in 1990.
People are clearly excited and the economy is likely to do well and that gives us a bit of a conundrum. Economy is doing rather well. That usually means the stock is doing rather well. Yet, we think that valuations, risk premiums, they've got ahead of themselves, elevated risk of a correction but not a bear market.
Wall: Having a look at bond yields because they have also risen and this to me doesn't quite fit as well because usually when bond yields start to rise, you get those investors who perhaps were taking too much risk in equities start to flow back into bonds as they see them as an attractive income opportunity. But that hasn't happened yet, has it?
Smith: Well, there's still quite a premium to be gained from investing in equities relative to bonds. So, yeah, that sort of incentive to investing in equities is still there on a valuation point of view. But that sort of divergence that you highlighted that it can be a bit unusual is, again, another reason why we are a little cautious, tend to think or at least I tend to think that bond markets are a little smarter than equity markets. There's usually less noise in bond markets and equity markets often get it wrong.
Now, if we look at bond yields, you can break them down into three components. Real rates, which is really the growth element, the economic element of bond yields; inflation expectations and the term premium, which kind of reflects supply and demand uncertainty and that's the part that QE acts through. Now, the real rate component, that economic growth component of bond yields, has fallen in the U.S. since Trump came to power.
So, actually, that's saying something very different to equity markets. What's driven bond yields higher are inflation expectations and so link that back, inflation expectations without growth, that's not great by anyone's standards and it's about the term premium has driven about 60% of the move in bond and bond markets. And that's really been about improving macro in Europe, which means the ECB will probably do less QE in the future and that's been driving up term premiums because less QE, less demand for those bonds.
Wall: Now, this time of the year with just over a month to go to the end of the tax year, is normally the time when people start looking for new investments for that ISA allowance sprinkling their portfolio. If people were looking to invest today, where would you say the greatest opportunities are?
Smith: Well, last year, we had a lot more positive on the growthier end of tech and also on banks. Now, the growthier end of tech has just done so well. We don't think it's going to collapse, but the technicals aren't there. Similarly, with banks and financials, they have beaten some of the more defensive names by 40%, 50%. So, again, there's a lot scary technicals out there, which means on a very tactical basis, not there.
We still advocate sticking with the strategy that has done well quarter in and quarter out for the last few years and that is quality cash compounding growth. One of the few styles that has consistently performed well is high return on equity and particularly, high return on equity without too much leverage. In the first month or so of the Trump Presidency, the end of 2016, that did underperform for obvious reasons as value really got ahead of itself. But in 2017, we've started to see that keep pace again even though some of the more sort of risk-on moves have continued. So, yeah, it is bit boring, but high return on equity, quality cash compounding companies regardless of sector.
Wall: Ed, thank you very much.
Smith: Thank you, Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
