Henderson: Will Europe sing to a Trumpian tune?

It was hard enough to imagine him as a good steward of the US economy, let alone in charge of the nuclear codes. In the event of his election, after a brief wobble, equity markets have moved to record highs, quickly deciding that the Trump regime of tax cuts, infrastructure projects, deregulation and defence spending would give the US a Ronald Reagan-style economic boost.

A bonfire of regulations

Stock market beneficiaries have included construction-related companies, defence contractors and banks, where followers expect a bonfire of regulations. Banks also benefited from a sharp reversal in the bond market, which quickly moved to price in expectations of higher government spending and rising inflation. Yields on 10 year US Treasuries moved from 1.8% to nearly 2.4% in the space of just three weeks.

Europe has followed a paler version of the same pattern, with a rotation away from defensive growth companies – the so-called bond proxies – into cyclicals, defence, value stocks and banks. The question now is whether this sectoral rotation is finished or if it will continue.

It may be false optimism…

In terms of the US it is not entirely clear how quickly Trump can deliver infrastructure projects that can have a meaningful economic impact – Obama tried the same idea without much success. And Trump’s tax proposals look likely to benefit the better-off, who tend to spend less of any extra income. Even if US corporates are allowed to repatriate cash without fiscal penalties, it is possible that more of this cash will be used for buy-backs and acquisitions rather than fresh investment, because of the difficulty of finding attractive greenfield projects where a return can be achieved. And while Trump’s more extreme ideas about foreigners may be quietly forgotten, if he does make life more difficult for immigrants, this is hardly likely to have a positive economic impact.

…but markets are still rotating

Even though the anticipated real US economic impact of Trump may be overstated, in the shorter term the stock market may simply continue to benefit from people taking money out of the bond market, where real returns – even after the recent move – still look low. This cash will be looking for a new home at a time where the risks for inflation appear to be on the increase, a fear likely to be reinforced by the apparent agreement by OPEC to reduce oil production.

Europe, as always, is more complex. Bond yields here have moved up, following the US, but remain much lower. Weak European growth means that the European Central Bank (ECB) is a long way away from increasing interest rates – unlike the US. It is more a case of a debate about how quickly the ECB ramps down its programme of QE. Share prices of banks have risen on the hope that this means an end to even more negative rates and more aggressive QE.

Rise of the demagogue?

The political backdrop in Europe is also complex. Following the recent Italian referendum on constitutional change, Europe is hosting a mini marathon of elections in France, the Netherlands and Germany stretching into 2017. These are likely to feature the same issues and debates that surfaced in the UK’s referendum on EU membership and the US presidential election. After observing the results in the UK and the US, my guess is that incumbent politicians will meet the populist challenge by stealing their arguments and singing Trumpian tunes. How about some more spending on infrastructure? How about some new houses? Let’s ease back on austerity. Let’s review minimum wages. Let’s review immigration arrangements. Let’s improve security by spending more on defence. So these sectors are likely to be the obvious talking points in the coming months.

Some defence contractors enjoyed strong runs even prior to recent weeks. Leonardo (formerly Finmeccanica) is an exception as there were concerns over its management team until recently. However, it offers a position as one of the leading global makers of helicopters, together with a decent exposure to defence electronics. It has plenty of opportunities to improve margins and cash flow and yet is also one of the cheapest names in the sector, offering a free cash flow yield approaching 10%.

Safe footing for valuations

Elsewhere there are other opportunities where valuations are modest. It is not true that equities only look cheap compared to bonds. Take flooring company Tarkett, which is controlled by a French family. The company has been built up partly with the help of buyout house KKR but now offers a European alternative to successful US names such as Mohawk. Yes, flooring (vinyl, linoeleum, wood laminates etc) is boring. But 80% of the business is refurbishment and, overall, it is not capital intensive, so generates plenty of cash. Think of another well-known investor in flooring? Warren Buffett.

Another boring product area is tyres. Personal transportation, and everything that we eat and drink (and much more) goes around on tyres and will continue to do so even if vehicles switch to electric power. The tyres business is also an oligopoly, with the global industry controlled by a handful of brands. Despite having the most expensive tyres, Michelin for many years contrived to produce the lowest margins and the least cash of anyone in the industry. But the first non-family manager of the company is finally changing that. Outsiders have not yet fully recognised the change so the valuation still looks relatively modest.

Relying on self-help

Obviously, if the sell-off in the bond market continues, it will affect equity values, because of the need to use a high discount rate in valuation models. That said, by looking at good companies on lower earnings multiples and where there are ample opportunities for self-help, it should be possible to weather the political turbulence of the coming months.