Tax reform proposals from the Trump administration have largely contributed to a return of the reflation trade during September, with the sharp increase in interest rates and steepening of the yield curve leading value stocks to outperform growth. The increase in market-based inflation expectation measures, rotation in equities towards small-cap companies and cyclical sectors, and rebound in the U.S. dollar were also in-line with the reflation trade. Although the tax plan was largely in line with expectations, market participants appeared more optimistic that tax cuts will be enacted in the end.
If enacted, Trump’s tax reform framework would cut the corporate tax rate to 20% from 35% currently and enable corporations to repatriate overseas cash at a lower rate, which would be expected to boost stock buybacks and profit growth. As a result, risk assets maintained their positive momentum and market volatility stayed historically low during the month despite shocks from North Korea tensions and hurricanes.
Although we remain confident that Washington will ultimately enact a tax reform, we are of the view that the equity market is already pricing in a significant probability of successful tax reform legislation with the S&P 500 trading at 18x Forward P/E and analysts’ consensus long-term earnings growth expectations over the next five years for the S&P 500 currently standing at 13.7%, a new high since May 2002. For the sake of comparison, long-term profit growth expectations were only slightly above 9% in early 2016, which illustrates the significant jump in analyst expectations. This makes equities particularly vulnerable to disappointments, in our view.
In spite of the fact that global economic data is holding up well and that the global recovery remains well synchronized across regions, risks on the horizon threaten to derail investor optimism with the current tightening in financial conditions possibly weighting on risky assets and economic growth down the road. We also believe that inflation data will strengthen into year-end with the output gap in both the U.S. and Canada expected to close by the end of this year, our expectations for a rebound in oil prices and as a lagging effect to the recent pick-up in global manufacturing indices.
Rising inflationary pressures into year-end presents a key risk for risky assets as higher inflation may drive price multiples lower. Also, increasing signs of earnings momentum slowing may lead to a market pullback at some point as past turning points in the earnings cycle historically preceded shakeouts in reflation assets. Indeed, the global net earnings revisions ratio remains on the decline and the year-over-year change in both the U.S. coincident economic indicator and industrial production appear to be peaking, all signs that historically tended to precede a tipping point in earnings growth. We remain neutral on equities.
Regional & Sector Allocation
There is no change to our regional allocation this month with our largest overweight remaining Canadian equities. Canadian stocks remain historically cheap relative to U.S. equities and we continue to expect the global oil market to tighten in the coming quarters, which should exert a positive influence on oil prices.
There is no change to our sector allocation this month. In Canada, we still favor the Industrials, Information Technology, Telecommunication Services, Financials and Energy sectors. In the U.S., we still advise clients to overweight the Information Technology, Health Care, Financials, Real Estate, Telecommunication Services and Energy sectors.
Canadian Bond Allocation
Last month, we cut our overweight position in corporate bonds to neutral as our model was taking a more cautious approach. We maintain our neutral stance to corporate bonds as spreads are historically tight and the global net earnings revisions ratio remains on the decline. Corporate spreads could also widen as central banks start withdrawing monetary stimulus as past declines in central bank net asset purchases coincided with widening credit spreads. Indeed, decelerating economic growth combined with an increase in borrowing yields could hurt corporate fundamentals and the relative performance of credit. With the output gap in both the U.S. and Canada expected to close by the end of this year, this should also exert downward pressure on the profit margin outlook as margins historically tend to peak soon after output gaps close.
