Welcome to the November edition of the Burrell Blog for 2016.
The election of Donald Trump as the US President-elect was not a result predicted by the pollsters or the markets.
The global audience was transfixed by the spectacle. At 4am Brisbane time, a Florida exit poll on Bloomberg TV showed the probability of Clinton winning Florida at 60% and other high probabilities for key eastern USA states. Six hours later, the map was not blue but red and as the hours wore on, the outlier result became the reality.
The US Electoral College voting system was a compromise by the founding fathers between one group who wanted popular election of the US president and the other wanted Congress to elect the president. The compromise involved each state being allocated a number of electoral votes equal to the number of seats in the congress held by that state plus the two senators for each state. Thus Florida has 29 Electoral College votes and California 55. The founding fathers then decided that whoever won the state by popular vote would receive all of the electoral votes for that state, with the exception of two minor states which use a proportional system. Hillary Clinton was expected to take at least one of Florida, Pennsylvania or North Carolina, but in the event did not and thus lost the election. In the states that Clinton won, she had an excess of votes to the majority of 100,000 which Trump held in total over the three key states. For this reason, the statement is made that Clinton won the popular vote, while Trump did not (ie. more than 50% of votes across the USA). However this is simply a result of the USA electoral system.
The unexpected results saw the markets fall as the electoral votes were shown on the television and global markets were down considerably on the day. After a surprisingly conciliatory acceptance speech in which infrastructure spending was outlined as a key stimulus for the USA economy, the markets recovered all of the lost ground on the next day.
Much is being written and said as the follow on from these events. The focus of your diarist and our personnel is primarily on the following key economic attributes which are likely to play out in an environment where the Republican party controls the Congress and the Senate but may not support the views of the president on all issues and so the President-elect will have to compromise with the Republican party on some aspects of policy, albeit that the President-elect has a mandate on several issues.
To comment on the key issues your diarist has focused on to date:
- - Ten year bond interest rate increase
The graph below shows that the Australian 10 year bond has moved from a low of 1.9% to 2.7% ie. by 0.8% in the past month. Burrells have long held the view that when longer term interest rates rise, those holding bonds will suffer significant capital losses. In the USA, the 10 year bond has risen by over 0.5% in the last few weeks.
The 10 year bond is the risk free rate, which is the basic building block in valuing asset such as bonds and shares. All other things being equal, an increase in the risk free rate means that future cash flows should be discounted more highly and so lower valuations will result.
The difference in this instance is that the markets have been looking for an excuse to increase longer term interest rates and in the USA, the consensus of many economists is that the US Federal Reserve has been lagging the market. The President-elect made the comment that he thought interest rates needed to raise and so they have.
A contributing factor in the first instance is the assumption that the President-elect will encourage borrowings to fund infrastructure and this may be so. However, there are also statements which indicate that companies with large cash balances overseas which have not been repatriated because they will be subject to US corporate tax, may now be given a tax holiday to bring these balances back to the USA and somehow channel some of this money into infrastructure.
It follows from the above that the President-elect sees the increase in infrastructure spending as increasing the economic growth rate in the USA from 3-4%. Obama had wanted to increase infrastructure spending, but the Republican congress had refused on the ground that this added to the already high US borrowing. Thus while the increase in interest rates is negative for stock valuation, the increase in economic growth resulting from an increase in infrastructure spending is positive.
The President-elect had a policy during the election of cutting US corporate taxes to 15%. Such an increase in cash flows to the US corporate sector would result in a material increase in valuations.
There is also a promise of individual personal tax cuts. Taken together, these promised tax cuts pursuant to traditional economic policy would lead to an increase in the deficit, some say to alarming levels. The contrary policy effect espoused by the President-elect is that cutting the corporate taxes will lead to an increase in economic activity and higher overall taxes being collected. This alternate view is unlikely to be accepted by the majority of leading economists in the USA and significant push back is likely. Never-the-less, even a modest cut in the corporate tax rate will be positive for US equity valuations.
USA Market Valuations vs Australia
The US stock market has enjoyed a period of sustained recovery in line with the recovery in the USA economy, shown by a fall in unemployment from 10% to 5% and increase in GDP growth rates. There are a number of sectors including consumer staples, health care and some selected technology stocks that are seen by several commentators including our overseas portfolio managers and your diarist as subject to correction. In Australia, health care, infrastructure, smaller telcos and some selected consumer stocks were also seen as overpriced, but the good news is material corrections have occurred in the price of several of these stocks over the past six weeks. There have been some downward moves in the USA e.g. in technology stocks such as Facebook and Netflix, but at a recent conference in Sydney, several leading overseas investment managers saw the overvalued sectors in the USA as more likely to have further downside potential on a valuation basis.
Other comments in respect to overseas economies were that China is performing much better than expected and so is Europe, with stockmarket valuations in Europe attractive, but perhaps reflecting concerns around Brexit and similar elections in 2017 in Italy and several other European countries.
In summary, the US election produced an outlier result. Global markets initially reacted adversely, but positive policies on infrastructure spending, company tax cuts and economic growth generally saw the markets recover. Against these positives are the headwinds of what appears to be a bottoming of the 10 year bond rates in the USA and Australia together with a degree of over valuations in the USA equity markets, but not in Australia. Leading US economists will dispute the effect of tariff and corporate tax cuts.
Our view is to consider companies on an individual research report basis and to look for good value in these current conditions. Likewise, stocks on high valuation multiples not justified by likely future growth in Australia and overseas should be exited.
The themes for 2016 remain a helpful guide post and are listed below.
Themes for 2016
↗ Dividend yield driver
↗ Interest rate cycle headwind
- Central banks in different parts of the cycle
↗ Segment stocks in Burrell Universe into four segments
- Other high yield, but steady/lower growth
- High growth & sound business model, management, Balance Sheet, ROE > 10%
↗ Adopt a realistic view on China, not a sentiment view
- Markets whollyreactiveto China as a proxy to demand growth for energy & mineral resources. There is relatively well developed themes so looking for inflection points in calendar 2016.
↗ US economy and the USD
↗ Digital disruption and competition
↗ Australia innovation stocks: medical appliances; global champions
↗ Weaker resources sector = lower A$ = Mergers & Acquisitions (M&A)
↗ Deloitte Fantastic Five: agribusiness, gas, tourism, international education and wealth management
↗ Property: more positive moves driven by low interest rates, demand and low valuations
↗ Possible X factors
- US stock market valuations and possible correction
- $20 oil
Disclaimer & Disclosure: Burrell Stockbroking Pty Ltd and its associates state that they and/or their families or companies or trusts may have an interest in the securities mentioned in this report and do receive commissions or fees from the sale or purchase of securities mentioned therein. Burrell Stockbroking and its associates also state that the comments are intended to provide information to our clients exclusively and reflects our view on the securities concerned and does not take account of the appropriateness of the recommendation for any particular client who should obtain specific professional advice from his or her Burrell Stockbroking Pty Ltd advisor on the suitability of the recommendation. Whilst we believe that the statements herein are based on accurate and reliable information, no warranty is given to its accuracy and completeness and Burrell Stockbroking Pty Ltd, its Directors and employees do not accept any liability for any loss arising as a result of a person acting thereon.
This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
Burrell Stockbroking Pty Ltd (ABN 82 088 958 481), a Participant of the ASX Group and the NSX.