US: Policy unleashes animal spirits
The performance of US small and medium-sized companies has been boosted by an expectation of lower taxes and lighter regulation under President Trump. Christopher O’Dea reports
At a glance
• The shares of US smaller and medium-sized companies performed strongly in the wake of Donald Trump’s election as US president.
• Smaller companies are hoping for a lighter regulatory burden and lower taxes under President Trump.
• Protectionist measures could hurt smaller companies by making imports more expensive.
• Tighter immigration controls could raise labour costs.
Bigger is not always better. In fact, since the election of Donald Trump, investors have been handsomely rewarded – by a wide margin – for holding shares of smaller and medium-sized companies, which are often more intently focused on domestic markets than overseas opportunities.
“That notion isn’t lost on investors,” says Jack Ablin CIO for BMO Financial Group’s Private Bank. Smaller companies, as represented by the Russell 2000 index, gained 15.1% from election day to the end of the year, Ablin notes. They were outpaced only by the 15.5% gain in crude oil. Large-cap US equities lagged substantially – rising just 5.9% in the post-election rally to the end of the year.
“Having swept to power with the promise to ‘make America great again’, a Trump administration is perceived as being particularly supportive of smaller, US domestic industries and companies,” says Helen Driver, global equities fund manager at Aviva Investors.
The benefits for small and mid-cap companies include financial factors such as reduced regulation and lower taxes. Restrictions on global trade would favour some high-potential US small-cap sectors that provide research-driven goods and services. Reduced immigration, on the other hand, could raise labour costs in some service sectors. However, the impact would be variable. Companies with pricing power would be able to pass on costs as higher prices and automation has reduced the labour component of many US service industries.
But the biggest benefit is the change in sentiment. “Many CEOs have been reluctant to invest,” says Matthew Litfin, co-portfolio manager of the small and mid-cap Columbia Acorn fund.
“The feeling now is that rather than having regulatory guns aimed at them, companies will be able to focus on longer-term growth plans and expansion,” he says. “The promise of the new administration has rekindled animal spirits.”
Reducing tax and regulation will benefit smaller companies relative to larger ones, says Ablin. In terms of the burden they impose on a company’s cost base, “regulations are pretty much equally weighted,” he adds.
“Sarbanes-Oxley [the 2002 Act], for example, requires a company to go through the same process whether it’s a multi-billion dollar company or a smaller one.” Consequently, he says, “anything that helps pull that back should help small companies benefit more so than larger ones.”
Trump’s call for a large infrastructure programme is likely to boost larger companies first, says Driver, but any gains are contingent on when – and whether – any new funding is made available. “Greater spend on infrastructure will undoubtedly help smaller firms too, in time, whether they supply plant, machinery or labour for large-scale projects,” she says.
“But while big business might be at the front of the queue in any infrastructure spend, we first need to see firm budgetary commitments and contract awards before any shovels break the ground and benefits trickle down.”
Taxation is another area where the Trump administration is expected to bring about policy changes that are likely to boost the financial performance of small and mid-caps.
“Over the past 30 years many of the largest companies have used the rules of the game to benefit their situation,” Ablin says, “whether through utilising global supply chains or taking advantage of the ability to locate operations in low-tax jurisdictions.”
Without being able to take advantage of the same tax-saving measures available to larger global firms, smaller and mid-sized companies have had to pay relatively more tax. “That leaves the smaller companies, which tend to be more domestically focused, paying a much greater share of taxes than their size would suggest,” Ablin says.
Periods of policy revision – even when positive changes seem on the cards – can also bring risks, and the danger is perhaps never greater than when the tax code is in play. Trump’s tax plans are intertwined with his economic nationalism. “There is talk about a border adjustability tax,” Ablin notes.
This policy would favour domestic production and sales abroad by imposing an import tax and granting exports a subsidy. “My view is that smaller companies tend to be importers, and they would be incrementally disadvantaged under that scenario versus exporters.”
Of course, larger companies with global supply chains might also fall foul of any new taxes on imports, and that would tend to neutralise the disadvantage that smaller importing firms might suffer from new import levies.
While the effect would depend on the supply network of a given company, Driver says the net result is likely to be that, in light of the more localised supply chains of smaller companies, “domestics would be better insulated should the Trump administration choose to impose or raise taxes on imports, which would cause greater pain to those larger companies operating global supply chains”.
While a border tax is a risk to watch for, its effects may be some way off because any such a levy could prove difficult to impose. “We’re not sure if that is even allowed under World Trade Organization rules,” says Ablin.
Trump’s popular campaign plank – controlling immigration – is likely to raise labour costs. “Prior to the election the US economy was already at or near to full employment,” says Driver. Reduced immigration would increase wages, inflation and interest rates, she adds.
“A tighter jobs market and higher wages may be what some of Trump’s supporters voted for,” Driver adds, “but how this is balanced alongside rising prices and interest rates will be critical for the US economy.”
While immigration policy has “less direct effect for small and mid-caps than tax policy,” Litfin says rising wages would have the most severe impact in service sectors, such as restaurants. “The restaurant industry is labour-heavy, and likely always will be,” he says, and higher labour costs “will separate wheat from chaff.” Companies with pricing power “will raise pricing power to the extent they can, and those that can raise prices will maintain margins.”
Litfin contends that US small and mid-cap shares offer an opportunity to take part in a resurgence of US growth, tap global markets, and avoid the annoying side-effects of Trump’s controversial policies.
“Potentially protectionist US policies are an overhang for all global equity markets,”
Litfin says, and smaller US companies have an edge in that environment. “The percentage of revenue derived from the US market by small and mid-cap companies is much greater than for large caps.”
Litfin suggests the key question for investors is: “What does the US do well on a global basis?” The answer, he says, points to two of the most promising global sectors: technology and healthcare, in particular drug development and biotech. “Both require research and development, they are easily exportable, and they tend to be universally applicable,” he says. “A pill developed in the US can be swallowed by a human in France.”
For overseas investors “US small and mid-caps are a good place to invest”, says Litfin. “One of the main reasons for that is that you are able to tap into the biotech and IT sectors in a way you can’t if you are allocating that capital to other regions.”
The other key factor is the improving economic environment. “The climate for doing business as a US company, in my opinion, will be better, and that makes for a more attractive investment climate,” Litfin says.