By Mustafa Sagun, Chief Investment Officer, Principal Global Equities
Trump's win caught the equity market by surprise. Trump was supposed to be "the Risk-Off" candidate by most equity strategists' expectations but the U.S. equity markets have been on a tear in the first couple of days of his surprise win. What changed?
Republican sweep, Republicans retaining both the U.S. House and Senate, reversed all expectations. Equity investors quickly realized that Republicans have a great opportunity to push their pro-business and pro-growth agenda for the next two years. If they do it right, they will retain Congress and the House in mid-term elections, which will give them another two years to carry on their agenda.
Pre-election, talk is easy and cheap. After the election, it is time to implement. From a purely pragmatic position, the question is: What is easy-to-implement first with maximum impact? President Trump and the Republican House and Senate need to unite and focus on their joint agenda where they can get the highest impact with minimal economic and political cost.
So this will not be about building a wall at the Mexican border or even about what "candidate" Trump said in his campaign, it is about what "President" Trump can do with full Republican backing.
The Republican agenda will take the front seat which translates into less regulation and lower taxes. This is growth positive. Lower corporate taxes, large scale deficit financed fiscal stimulus and deregulation will likely result in higher growth and higher inflation expectations. This suggests the yield curve steepening can persist. More U.S. Federal Reserve (Fed) Funds rate hikes will become increasingly likely in 2017-2018.
We will likely see less regulation in financials, healthcare, and energy sectors which will likely lower costs that these companies are facing. Although the compliance industry may see a bear market, it may be earnings accretive for these companies. However, not every stock in these sectors will benefit. That is why we have seen sharp stock price movements even within sectors while the markets are trying to align with a potential structural shift in these industries. There are winners and losers in each sector and active management is even more important in this situation.
For example, in financials, deregulation will likely loosen capital requirements resulting in higher returns on invested capital, a result that equity investors would like. Repeal of 2010's Dodd-Frank Wall Street reform law is an easy target. Modifications have already been drafted but did not get implemented because of a likely veto by President Obama. The clear beneficiaries of such a move would likely be banks with assets over $50 billion. We would expect an increase in their returns on equity (ROE) potentially resulting in outperformance in super regional bank stocks.
In addition, markets have rapidly adopted a viewpoint that Trump's pro-growth agenda of lower corporate taxes, large-scale deficit-financed fiscal stimulus, and deregulation will result in higher growth and inflation expectations. Markets have broadly adopted a "lower-for-longer" viewpoint which is embedded in the current depressed equity valuations of bank stocks. With a steeper yield curve, there is potentially more upside to bank and life insurance earnings and valuations.
As for the Department of Labor (DOL) Fiduciary Rule, a recent flurry of research suggests that Trump will freeze its implementation and repeal it later. Although, we believe the repeal or replacement of this ruling seems like a poor use of early political capital, we hear from political analysts that Republicans are willing to prioritize in their agenda. Some asset managers and life insurance companies would be clear beneficiaries.
On the healthcare front, the possible repeal of Obamacare and reduced drug pricing rhetoric have been driving healthcare stocks. This poses headwinds for hospitals and some managed care companies but is likely favorable for pharmaceutical and biotech companies.
That said, we continue to see structural issues keeping drug price increases in check (narrow formularies, value-based healthcare, payer and pharmacy benefit manager pressure on drug prices in competitive categories). The drug industry for the most part has been keeping price increases under 10% to stay out of the spotlight over the last 12 months. That level of restraint is healthy and sustainable.
For Medicare, Republicans have been broadly supportive of the privatization of Medicare (i.e. Medicare Advantage). This would be positive for the managed care companies most exposed to Medicare Advantage.
For Medicaid, there is more risk. Republicans have been critical of the broad funding within the Affordable Care Act (ACA) for expansion of Medicaid, favoring block grants to the states for Medicaid coverage. If the ACA is repealed and block grants to the states are instituted, Medicaid expansion would slow, negatively impacting certain companies. It is highly unlikely, however, that current Medicaid coverage would actually be reversed, leaving members without coverage. Any changes to Medicaid would be expected to be incremental over time. The more likely scenario for ACA is "amend and improve" rather than "repeal and replace."
In addition, Corporate Tax Reform and Repatriation creates more opportunity for large cap pharma/bio and medical devices as we could see a merger and acquisition (M&A) spree based on lower corporate tax rates and potential repatriation of cash.
So we believe the winning equity strategy is to align with the Republican agenda, not the "candidate" Trump agenda. As these agendas intersect, they are likely to create structural shifts in these industries. As always, stock picking is the key to differentiate within these industries.