There are some current factors like Trump’s tax reform, infrastructure investments programme and trade tariffs, that most probably have affected the asset valuation in the last months. The question is if the impact of these Tump’s policies is so relevant to compensate the apparently overvaluation that American equity markets seem to have. However, Russell 2000 is possibly the clearest example of this. It is one of the main American stock exchange indexes, composed of 2000 small caps that have the distinguishing feature of having trailing 12 months P/E ratio of 130.5x and 120.3x after cyclical adjustments. It seems to be a very good opportunity to be short, or at least to keep in mind in the case market tendency changes. Our trading algorithm has given already a signal to take a short position in Russell 2000. We will now try to analyse the fundamentals of its valuation in more detail in this article, and in the following ones.
Firstly, it is important to mention the possible reasons that have facilitated such good performance of Russell 2000 over the last few years. In my opinion, these are:
- Trump’s tax reform that benefit small companies the most, as they are more exposed to the domestic market than the large caps.
- Public infrastructure investments could also benefit the small caps the most.
- Anti-trade policies that could give subsidies to non-competitive companies, and small caps would be one of the main beneficiaries.
- The financial sector makes up about 20% of Russell 2000. The higher long interest rates and more flexible regulation, could allow companies in this sector to take off.
Trump’s tax reform will most probably move growth from the long to the short term.
As an aplication of the tax reform, the law cuts corporate tax rates permanently, and individual tax rates temporarily which are expected to expire after 2025. The tax reform can be quantify in an amount of tax reduction of $1.46 trillion, and the impact on GDP growth expectation varies depending on calculations, but goes from 0.8% in ten years according to the Joint Committee on Taxation to 0.7% annually calculated by the Treasury’s Office of Tax Policy. The amount of public debt increase also fluctuates, depending on the source of calculation, and goes from $300 billion decrease to an increase of 2.2 trillion. Chart 16 summarises the results of the calculations for different organisms in relation with the tax reform.
|Impact of tax reform||Institution||Impact on GDP||Public Debt Increase|
|1.46 trillion USD||Treasury’s Office of Tax Policy (OTP).||The Treasury expects an 0.7% increase in growth from 2.2% to 2.9%. It has modeled the positive revenue impact of higher growth effects, using the Administration projections of approximately a 2.9% real GDP growth rate over 10 years, contained in the Administration’s Fiscal Year 2018 budget.||$300 billion decrease in debt.|
|The Joint Committee on Taxation’s (JCT)
|JCT estimates that this proposal would increase the level of output (as measured by the Gross Domestic Product) by about 0.8 percent on average throughout the 10- year budget window||$1.0 trillion.|
|It projects growth of 2.5% in 2018, 2.1% in 2019, 2.0% in 2020 and 1.8% in the long term.||N.A|
|Committee for a Responsible Federal Budget (CRFB)
|Increase GDP by 2.86 percent over the current baseline forecasts, or an average of 0.29 percent per year.||$0.45 trillion.|
Public infrastructure investments could benefit the small caps the most, but only in the short and medium term.
In addition of tax reform there has been implemented an infrastructure investments plan. It consists of $200 billion federal funding for infrastructure investments over a decade, mostly for incentive states, localities and the private sector to find another $1.3 trillion to complete the investment programme. It also includes a streamlined environmental review process, which in the past has added years to the completion time for infrastructure projects.
There are three possible financing sources for the infrastructure investments (or a combination of them) and the three with similar consequences:
- Public funds as a combination of federal, state and municipality funds. In the short term, the domestic economy will benefit, and therefore the small caps will be in a better position than the large caps. Between them, the ones operating in the infrastructure sector or activities related with it, will most likely get the better part. But in the longer term, the public debt will have to be repaid by increasing taxes, that will suppose a burden for the domestic economy. In addition the mentioned tax reform will increase this problem.
- Internal savings. In this case there is only one way to do it and this is by reducing other public or private investments in order to have funds to finance the infrastructure investments. Theoretically, there is another method to achieve this purpose, by incrementing internal savings by reducing the consumption. In any case, if the programme has to be financed by internal savings, it will reduce investments or consumption and so the net impact in domestic economy will be negligible.
- External Debt. We expect the attraction of this amount of funds to only be possible if there are increases in American interest rates, that could come about over the next decade. In addition, the interest rate will most probably increase as a result of growth in the domestic economy, fed by external funds that will raise the monetary demand. But the entrance of foreign funds will tend to rise the exchange rate of USD and reduce exportation. If the USA were a small economy, the increase in investment would be compensated by a reduction in exports, but this is not the case. On this occasion, the situation is more similar to a big open economy, which is clear considering that $1.5 trillion of investments is an amount equivalent to 50% or 128% of the German or Spanish GDP respectively, which it is a relevant quantity for the international economy. So we can expect that the international interest rates will also tend to increase as a consequence of the rise in monetary demand, and therefore the surge of exchange rates and exports will be mitigated. Although the net effect will be positive in the short term, boosted by an increase in domestic investment and subsequent reactivation of domestic demand, external debt will have to be repaid sooner or later. Consequently, in the longer term, national savings will have to increase at the expense of less consumption and/or investments in order to increase exportation, that will be the source for repaying external debt. In this sense, it is again a way to finance short term growth by reducing the longer term. For further clarifications, Spanish speaking readers can consult the following publications:
- Explanation of the operation of a large open economy: Una gran economía abierta y sus implicaciones en política económica.
- Explanation of a tax reform in a small open economy: ¿Bajar impuestos para estimular la economía? Depende. ¿Sabes por qué?
- Explanation of the operation of a small open economy: El modelo de Mundell-Fleming, pero para que lo entienda todo el mundo
In addition, there is another risk in the longer term. The infrastructure investments will suppose almost 8% of the annual national GPD, and with such an amount, expansion to production capacity will most likely be the result in the sectors involved in the infrastructure investments plan. After the infrastructure investment is finished, there could be a risk of generating overcapacity with the withdrawal of aid. But being realistic, I do not expect this threat to be a great concern for the financial market, as it is very much a long term risk.
Anti-trade tariffs could provide subsidies to non competitive companies and small caps, and these would be the main beneficiaries.
At the beginning of March 2018, Trump announced tariffs of 25 percent on steel and a tariffs of 10 percent on aluminum imports. One week later, he signed an order to make the tariffs effective after 15 days. Canada and Mexico will be exempt from the levy, and he left the door open for other countries that will have to be studied case by case. But the exemptions for Canada and Mexico are not permanent. They depend on renegotiating NAFTA to Trump’s liking.
If the anti-trade tariffs programe ended here, the issue would not be at all relevant. However, this could suppose the beginning of a wider protection programme, extending to other sectors.
The possible consequences of these polices are summarised below:
- Obviously steel, aluminum and any other sector (small caps between them) that could be affected in the future will benefit, but this will be offset by the increase in cost and reduction of competitiveness of companies that use these protected materials. Finally, the entire domestic economy will be negatively affected.
- Tariffs reduce the incentives of improving competitiveness. In fact, they are a subsidy financed by consumers to sectors that are not able to be competitive in an open market with foreign operators.
- It is a very dangerous zero-sum game. It could provoke similar tariffs implemented by other countries, increasing the risk of a disintegration of international trade, with disastrous consequences to the global economy.
We do not expect any positive consequences of the anti-trade tariffs plan either in the short or long term. But neither do we expect significant negative implication. According to Trump’s declarations, until now, it seems just to be a signal to some countries like China that permit some of their companies to practice damping and other types of unfair trade. If we are wrong and it could suppose the beginning a broader protective policy it would be enough to expect the beginning of a recession period.
For further clarifications, Spanish speaking readers can consult the following publications:
- For an explanation of the historic context about protectionism: “El “America first” tiene muy malos antecedentes”
The higher long interest rates and more flexible regulations could allow the financial sector to take off.
Considering that the financial sector makes up 20% of Russell 2000, and even in the hypothetical case of an increase of 100% in EPS of companies of this sector, the PE of the index would only improve to 104x, that is still extremely high.
We will analyze in further publications if the rest of the mentioned factors could justify the current Russell 2000’s valuation.