For the past year, Deutsche Bank was one of the most stubbornly pessimistic banks. Then, overnight, everything changed for one reason: Donald Trump.
The German bank laid out its 180-degree change in opinion in a 30-page Friday note titled “Trump: the huge picture for stocks”, in which it revealed that it now expects the S&P to easily rise to 2,250 by Trump’s inauguration, and then rise to 2,500 by 2018 “before suffering its next bear market.”
While not necessarily the “huge picture”, here is the big picture summary of DB’s note:
In the first week of President elect Trump, most of our investor conversations centered on their concerns about a higher fiscal deficit lifting Treasury yields and pressuring PEs and a stronger dollar/ weak oil prices pressuring the EPS outlook and the possibility of protectionism. While we don’t ignore such risks, we think the market is under appreciating the likely big boost to S&P EPS from a lower corporate tax rate and the boost to Bank profits from rising yields (and lower pension expense) and the much higher chance now of a long lasting economic expansion that rivals the 10 year US record. We’re more confident now that the S&P will reach 2500 in 2018 before suffering its next bear market.
The key reason for optimism: a surge in corporate earnings as a result of corporate tax reform, which as Goldman noted yesterday, will mean not only lower taxes but the $200 billion in offshore cash which will be repatriated will be mostly used (some $150 billion of it according to Goldman) to fund stock buybacks
With corp. tax cuts S&P EPS should be at least $130 & $140 in 2017 & 2018: We’re unsure how much the US corporate tax rate will be cut, but we think a significant cut is likely, and we see ~25% as most likely because it aligns with the OECD avg., it shouldn’t raise the deficit more than 0.75% of GDP, it significantly reduces repatriation taxes and it provides small businesses that want to reinvest their profits for growth a more tax efficient alternative than pass trough entities generally taxed at higher individual rates; this alternative would be especially attractive if the C class dividend tax rate is not over 15%. We’re unsure what happens with personal income taxes, but we don’t see cutting the top marginal income tax rate as the top near-term priority if C class treatment can be made more attractive to small businesses. Every 5pt cut in the US corporate tax rate from 35% boosts S&P EPS by $5. Assuming that the US adopts a new corporate tax rate between 20-30%, we expect S&P EPS of $130-140 in 2017 and $140-150 in 2018. We raise our 2017E S&P EPS to $130.
As DB notes, companies with the highest effective tax rate, which generally stems from a high domestic share of profits, have the most to gain from cutting the US tax rate. Companies that pay very low effective tax rates on their foreign profits will have less to gain if a lower US corporate tax rate is the tax policy change used to encourage repatriation of offshore cash rather than a special repatriation holiday tax rate. If a company pays a 0% tax rate on foreign profits then they would need to pay the full (albeit lower) US statutory rate to repatriate profits. These companies would prefer a low special tax rate repatriation holiday or a move to a US territorial system. Thus, what Trump proposes is good for multinationals, but best for domestic companies with high tax rates.
Unlike SocGen (and others), Deutsche is also confident that even as Treasury yields are rising, they have a “long way to climb before threatening” the bank’s elevated PE multiple, although it admits that should the climb be too rapid it poses a risk to equities.
Treasury yields have a long way to climb before threatening our PE targets: We’re comfortable with the 17-18 trailing PE that our 2350 S&P target for 2017 end and 2500 in 2018 imply, provided 10yr yields don’t exceed 3% in 2017 or 3.5% in 2018. We stress our over-weights on big Banks and Health Care and see upside at Tech, Cons. Disc. and Utilities, but find valuations too demanding at Energy, most Industrials & Materials. Staples have FX risk. The pace of the climb in yields is as important as the destination, as any rapid climb in yields could shock real estate and fixed income and weigh on growth. However, this is why we think Congress will try to find the right balance in its fiscal package and why we think it important that the Fed hike at a moderate pace to prevent the labor market from overheating and to slow the ascent in long-term yields.
DB believes that 10yr investment grade bond yields would need to be 4.5%, and 10yr Tsy yields exceed 3.5%, before companies would face higher borrowing rate than what’s currently in place and thus hurt S&P EPS.
Finally, for those who believe the entire move is just a headfake, here is DB’s recommendation on what bonds to buy:
If you are OW bonds or need a reliable real yield asset then look to Utilities. Utilities benefit from: 1) a lower US corp tax rate given nearly 100% US profits and thus no FX risk, 2) likely continued 15% tax rate on dividends vs. income tax rates for interest income and the 3.8% ACA tax is likely dropped, 3) more Federal infrastructure grants and loans for transmission upgrades, 4) a safe haven for retirees and institutions looking to reduce fixed income exposure. We expect corporate sponsored pension plans to reduce their equity allocation in favor of long duration IG corporate bonds, but public sponsored pensions and retirees will still likely seek reliable real yield bond substitutes like Utilities.
Of course, with DB making a U-turn and saying buy now that the S&P is at all time high, we feel that Goldman’s warning (to be posted shortly) that the future is far less bright than assumed, may actually be the correct one for a change.