John Tobin

The timing of President Trump’s Tax Cut and Jobs Act – coinciding with the most synchronised global economic recovery since the 1950s – will boost company earnings globally during 2018, despite recent market volatility, says John Tobin, portfolio manager with US based Epoch Investment Partners.

“The variability in GDP growth across countries is at its lowest point in over 50 years. This solid global growth cycle is a major positive for economies and company earnings growth.

“Capex has rebounded strongly and US export and industrial production has risen significantly. Meanwhile, we are expecting the transition globally, from quantitative easing to quantitative tightening, to be slow, gradual and well telegraphed.

“In fact, despite anticipated QE measures, financial conditions will remain extremely loose. In the US, the Fed’s financial stress indicators suggest markets are still awash with liquidity.”

“The lower tax rate regime in the US will impact this liquidity, and along with US companies, beneficiaries of the lower tax rates will also include non-US companies with significant earnings in the US – including automotive manufacturers, global financial and pharmaceuticals, along with companies operating in the aerospace and defense industries,” Mr Tobin says.

These tax reform initiatives, along with the economic recovery being experienced around the world, bode well for those companies already generating free cash flow.

“The most significant changes of the recent US tax reforms relate to business taxes. Lower taxes mean higher company earnings and cash flow, and these changes permanently raise the path of after-tax earnings and cash flow, which is unequivocally positive for share prices.

“It is a good move for shareholder yield.

“History suggests the extra cash from corporate tax returns will flow mostly to shareholders through dividends, buybacks and debt reductions, rather than other sources.

“This environment will be favourable for equity strategies focused on identifying companies with growing free cash flow and a track record of returning excess free cash to shareholders.”

In terms of sector allocation, Mr Tobin says Epoch Investment Partners remains overweight in telecoms, utilities, consumer stables and energy.

“The key to producing superior risk-adjusted equity returns is the identification of companies with a consistent ability to both generate free cash flow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt repayments.

“The focus needs to be on companies which return a proportion of their market capitalisation to shareholders on a regular basis, while still reinvesting enough in the business to grow operating cash flow,” Mr Tobin says.

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This article, based on a presentation given to advisers on 7 June 2017 by John Tobin, portfolio manager with Epoch Investment Partners (Epoch), looks at the global economic environment and expectations for growth in the coming years.

The macro environment

According to John Tobin of Epoch, the global economy is doing “reasonably well” and the economies of developed nations are favourable. Despite recent shocks – Brexit in the United Kingdom, the collapse in oil and commodity prices that hurt Canada and Australia in 2015, and the ongoing expectations of a hard landing for China’s economy over the past few years – overall, there is a benign economic environment around the world.

An interesting trend is the synchronicity among developed economies that has resulted in the convergence of global GPD rates. As illustrated in Figure one, global GDP growth rates are converging around the two per cent mark for mature economies; Epoch expects developing economies to have GDP growth of three-to-four per cent.

While not the stellar growth seen in previous years, positive GDP growth is an encouraging scenario – so, are there things to be worried about?

There’s plenty to be worried about!

The key market risks ahead focus on the “known unknowns”, particularly risks brought on by the Trump Presidency, as well as the economic outlook for China. The downside risks posed by Donald Trump’s policy agenda include higher interest rates, increased protectionism, anti-immigration policies and geopolitical shocks. The possibility that trade relations will deteriorate substantially is a real threat to the US and other economies. Policies that add stimulus to an economy operating at, or close to, full employment will put inflationary pressures on the US Federal Reserve, which will in turn put pressure on US interest rates.

There are upside risks, which include tax reform, regulatory reform, infrastructure spend and faster credit growth. While tax reform and regulatory reform are expected, it is viewed by Epoch as more likely to be incremental than the game changer advertised during the election campaign.

The US corporate tax rate is high compared to many developed countries, and particularly high when compared to developing nations. As a result, even moderate relief in corporate tax rates would be supportive for companies and financial markets.

Epoch’s modelling shows that a five-percentage point reduction in the effective marginal corporate tax rate in the US would add $8-$10 to the earnings per share (EPS) of the S&P 500.

The impact of these unknown factors could be substantial, particularly when coupled with the fact that geopolitical events are continuing to create potential for uncertainty and further market volatility.

Meanwhile, outside of the US…

While the US is focused on the Trump administration, there are other global factors to monitor.

The situation in Europe is improving. Although Macron successfully defeated the right-wing agenda in France’s recent election, the populist forces and voices have not gone away. The unexpected outcome of the UK election will add further uncertainty to the way Brexit negotiations will impact both the UK and Europe.

Epoch believes the UK economy has held up well because the Brexit process has barely started; and, like many divorces, it is not expected that Brexit will be an entirely amicable separation. As the separation progresses, it is unlikely to play out smoothly without any economic consequences and associated impacts on financial markets and the UK economy.

China remains a big concern. It’s the world’s second largest economy, a major contributor to growth and while some growth is evident, there remains concerns about its sustainability. Figure three shows China’s contribution to world GDP growth, which has been considerable since 2010, rising from just over 20 per cent to just under 30 per cent in that period.

However, as illustrated in figure four, the rate of growth of China’s GDP is decreasing. From a high of 14 per cent GDP growth in 2007, the International Monetary Fund (IMF) forecasts China’s growth at just over 6 per cent by 2018.

Although China is trying to position its economy away from a dependence on exports and investments, to have a more balanced GDP with a reliance on consumption, it may be a difficult transition. The IMF projects a continuation of the gradual downward growth trajectory and a reminder of the potential for a hard landing in the future.

Two percent is the new four percent

A topic of many discussions at Epoch is the notion that ‘two percent is the new four percent’. The fundamental drivers of economic growth come down to two factors: employment growth and productivity. Across the developed world, each country faces the same demographic headwinds…populations are not growing, labour force growth is low, and productivity growth has slowed dramatically. As illustrated in figure five, relatively modest productivity growth plus slowing labour growth result in declining output and lower growth.

Lower GDP levels will naturally have a flow on effect to global equity markets, as will interest rate movements. While interest rates remain relatively low around the world, and are expected to remain so, the Federal Reserve is moving to gradually normalise interest rates.

Although the IMF projections (figure six) look positive and show modest increases in GDP for 2017 and 2018, Epoch is mindful that there are any number of exogenous factors that could interrupt this, such as:

• Terrorist attacks
• ‘Policy terror’ – for example, the Fed raises rates too quickly and puts the brakes on, or the European Central Bank (ECB) gets ahead of itself and starts to remove policy accommodation too quickly or too aggressively, that could be the policy mistake that upsets the scenario
• A Donald Trump led policy shift, such as protectionism, that could lead to a trade war that has negative consequences for world trade.

Financial markets at an all-time high

Globally, financial markets are riding high. As indicated in figure seven, the S&P500 and MSCI World Index are at all-time highs, while the MSCI Emerging Markets Index is the highest it has been in quite a few years. Where will it go from here?

There are three factors to consider when analysing the return from shares – how much of the return is due to earnings growth, how much is due to dividends paid, and how much is due to the expansion (or contraction) of price/earnings (PE) multiples?

As illustrated in figure eight, the period from 2012 to 2016 has been anomalous when it comes to the composition of sharemarket returns. Epoch’s analysis of the S&P500 and the MSCI World Index over this time found that the percentage of return attributable to the expansion of PE multiples is significant: almost 70% of the S&P500 growth over this period resulted from the expansion of multiples, while the rise in the MSCI was almost 85% composed of PE expansion.

Looking more closely at the MSCI (middle pie chart), earnings growth went down over this time, and yet stocks rose.

Over the longer term (third pie chart, figure eight), the true drivers of share price growth are earnings growth and dividends. Historical analysis shows these are the long-term drivers of growth and returns.

Epoch’s research found that while earnings growth made up 17.3 per cent of returns in the S&P 500 between 2012 and 2016, this is expected to rise to 50.4 per cent over the next 10 years. Similarly, dividends are expected to increase from 13.9 per cent of equity market returns to 40.7 per cent.

The rise in global sharemarkets has been driven by PE multiple expansion, which has, in turn, been driven by monetary policy – low to negative interest rates and quantitative easing programs that pushed interest rates to global lows. When you push the discount rate down, it causes PE multiples to rise.

Just as equity multiples expanded during quantitative easing (QE), there will be a gradual contraction of multiples as economies unwind their longstanding QE policies. In this environment, equity drivers will return to normal, with dividend and earnings likely to make up a larger component of returns.

In summary

1. The long-term outlook of mid-single digits remains intact with main drivers of growth unchanged (2% is the new 4%).
2. Interest rates remain relatively low around the world even as the Fed gradually normalises; the central bank has carefully embarked on a tightening program, while other central banks have yet to commence. They are where the US was two years ago – talking about how and when to reduce QE and accommodation.
3. The market will be less impacted by broad-based multiple expansion; dividend and earnings are likely to be larger components of returns and be the fundamental drivers of returns. Investment will focus on identifying companies with those characteristics, as they will drive returns in the future.
4. Geopolitical events create potential for uncertainty and further market volatility. This will be a constant companion going forward.

———

The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2017 Grant Samuel Funds Managemen

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John Tobin

Two per cent is the new four per cent for mature economies’ GDP, meaning that the long-term outlook for global equity returns is likely to be in the mid-single digits, says John Tobin, portfolio manager with Epoch Investment Partners.

“Global GDP growth rates are converging around the two per cent mark for mature economies, while we expect developing economies to have GDP growth of three-to-four per cent.

“The key market risks ahead focuses around the “known unknown” risks brought on by the Trump Presidency, as well as the economic outlook for China.

“The downside risks of Donald Trump include higher interest rates, increased protectionism, anti-immigration policies and geopolitical shocks.

“The upside risks include tax reform, regulatory reform, infrastructure spend and faster credit growth.”

Mr Tobin said the impact of these unknown factors is substantial, coupled with the fact that geopolitical events are continuing to create potential for uncertainty and further market volatility.

“For instance, a five percentage point reduction in the effective marginal corporate tax rate in the US would add $8-$10 to the S&P 500 EPS,” he says.

“At the same time, the ongoing strength in the US labour market is likely to drive a moderate acceleration in wages, with implications for inflation.

“Similarly, China’s contribution to growth has been substantial since 2010, rising from just over 20 per cent to just under 30 per cent in that period. But its GDP is now growing at a decreasing rate; from a high of 14 per cent GDP growth in 2007, its estimated growth is forecast at just over 6 per cent by 2018.

“Lower GDP levels will naturally have a flow on effect to global equity markets, as will interest rate movements.

“While interest rates remain relatively low around the world, and are expected to remain so, the Federal Reserve is moving to gradually normalise interest rates.

“Just as equity multiples expanded during quantitative easing (QE), we will see a gradual contraction of multiples as economies unwind their longstanding QE policies.

“In this environment, equity drivers will return to normal, with dividend and earnings likely to make up a larger components of returns.

“For US equity investors, the prospect of corporate cash flow growth, and potential tax reform, supports continued dividends and share repurchases.”

Mr Tobin’s research shows that while EPS growth made up 17.3 per cent of returns in the S&P 500 between 2012 and 2016, this is expected to rise to 50.4 per cent over the next 10 years.

Similarly dividends are expected to increase from 13.9 per cent of equity market returns to 40.7 per cent.

“This makes determining the correct investment strategy in the future, all the more important,” he says.

“Traditional valuation metrics based on accounting measures, such as price-to-earnings and price-to-book, provide no insight into a firm’s return on invested capital or its skill at capital allocation.

“A company’s true value should be measured on the free cash flow that it generates.

“Various accounting metrics to measure earnings can be distorted by accruals, and can be easily manipulated.

“Earnings are an opinion, cash is a fact.

“The ability of a company to earn a return on invested capital that is greater than the cost of capital is what makes the value of a business grow.

“The key to producing superior risk-adjusted equity returns is the identification of companies with a consistent ability to both generate free cash flow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt repayments.

“The focus needs to be on companies which return 6 per cent of their market capitalisation to shareholders on a regular basis, while still reinvesting enough in the business to grow operating cash flow at 3 per cent or more a year. Invest in these companies and you’ll find good returns,” Mr Tobin says.

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