The Federal Reserve sparked a trend of higher interest rates for the first time since 2008 on Wednesday, December 16, 2015[i]. Since then, the Federal Discount rate has gone up by many basis points (bps) numerous times. Although this increase seemed insignificant to some, the trend should continue changing debt structures and eventually profitability margins of corporations.

Graph 1

The main change comes from an adjustment in the Weighted Average Cost of Capital (WACC) for the average corporation. Since the increase in the cost of capital is interpreted as an externality, this would create a shift in the WACC from WACC-i to WACC-ii, as shown in Graph 1.

Figure 1

Taking a closer look at the WACC, it’s clear that an increase in the cost of capital will derive from the cost of capital before taxes [Kd] found in Figure 1. Going forward, acquiring money for corporations is going to be costlier, and as a result, fewer projects should be approved since more of them will become unprofitable. The result is that companies holding heavy debt burdens or negative cash flows will find it a lot more difficult to finance their losses. It will be interesting to see how industries perform against the S&P 500 in this new world of higher interest rates. If we treat this as a cycle, it began on December 16, 2015, and will end when the next time the Federal Reserve decides to lower interest rates again.

Tax Reform:

The U.S. Tax Cuts and Jobs Act is also a significant externality affecting corporations as it could decrease the cost of borrowing after taxes as shown in Figure 2. This should have a positive impact on earnings per share (EPS). Although the cost of debt (Kd) will go up, the amount paid in corporate taxes will go down. Higher interest rates and lower corporate tax rates have happened simultaneously only a few times in recent history. Given that these developments affect corporate profitability, they should become significant factors affecting equity performance for some time to come as these forces act as significant externalities on the market.

Figure 2

Historical Outlook:

Finding time periods where the Federal Discount Rate increased as corporate tax rates decreased can give us a clue as to what might happen in the future as both of these effects become more significant. Specifically, we can look at companies that outperformed the S&P 500 during periods of higher interest rates and lower corporate tax rates.

Graph 2

Graph 2 shows three periods when the federal discount rate increased as the corporate tax rate decreased: 1964 to 1966, 1979 to 1980, and 1987 to 1990. Although these periods are in different stages of the business cycle, they can serve as proxies to see which industries will outperform the S&P500 under these new conditions. To test these three periods against the S&P 500, a paired samples t-test with a 95% significance level was performed between 49 industries and the S&P 500[ii].

Null Hypothesis:

Alternative Hypothesis:

Table 1

Net Neutrality:

From the results shown in Table 1, the telecommunications industry stands out the most due to the changes in net neutrality laws, which recently have mostly been dismantled [iii]. This should allow telecommunication companies to increase their EPS as they expand their Internet services throughout the country[iv]. Although it is uncertain whether companies such as Verizon and AT&T will be able to increase their market shares, the demand for a more extensive telecommunications infrastructure is very likely as we get closer to 5G cellular technology[v].

Graph 3

Dollar:

The decline in value of the U.S. dollar, as seen in Graph 3, is also a significant trend that affects telecommunication companies with exposure to emerging markets since the USD has been decreasing significantly for over a year and is set to keep declining in 2018[vi]. As emerging and developing currencies continue to get stronger against the USD, it should be easier for people to acquire Internet services, which should increase revenue for telecommunication companies. This is because emerging and developing market economies will be able to spend more on infrastructure and increase private consumption as their purchasing power increases.

Global Growth:

From a macroeconomic perspective, emerging and developing country growth also presents an opportunity for telecommunication companies exposed to emerging market economies. Recently, revisions were made for emerging markets and developing countries to grow to about 4.5%[vii] in 2018. The fact that emerging market indexes have increased at a faster pace relative to the S&P500 is an indication that if this trend continues, emerging markets might outperform the S&P500 again in 2018, calculated by Figure 4 and shown in Graph 4.

Figure 4

Graph 4

Ratio analysis:

A closer look at the telecommunications industry suggests that the companies best suited to take advantage of these changes in the market are companies that should not be heavily impacted by the rising cost of debt. As a result, companies with the best liquidity ratios and cash reserves within the telecommunications industry should have an advantage over others that are not as liquid or overleveraged in the next couple of years. More importantly, companies that can use their assets effectively to generate profits, should be able to continue to grow at previous rates.

Table 2

Although the companies that stand out in Table 2 are AT&T and Verizon Communications, other companies such as American Tower also hold massive amounts of free cash flow to the firm (FCFF), which puts them in a prime position to increase their market capitalization and grow in a higher interest rate environment.

American Tower:

Table 3

American Tower Corp (Ticker: AMT) is an owner, operator, and developer of multi-tenant communications real estate. The company profits from leasing space for communication sites to wireless services and wireless data providers in the U.S. and abroad. Using the basic premise that a firm’s value is the present value of its projected future cash flow, we can get an idea of the company’s fair value using multiple-price methods for valuation as shown in Table 3.

Table 4

Deconstructing the EPS of American Tower in Table 4 reveals that it’s firmly poised for growth. Although financial leverage is increasing, the total asset turnover and total profit margin are also increasing, which is a sign that it’s putting its assets to good use. This is reflected by the fact that its return on assets has increased by 20% from 2016 to 2017.

Graph 5[viii]

This growth could happen via a combination of 5G technology expansion in the U.S. and higher wireless and broadband penetration in emerging and developing countries as shown in Graph 5. Specifically, high growth will be observed in countries such as India and Nigeria, where mobile broadband penetration is still low compared to other rapidly emerging countries.

Graph 6

Externalities:

American Tower is in a rare position to profit from higher interest rates, lower corporate taxes, deregulation of the telecommunications industry in the U.S., a declining dollar, and rising global growth. If deregulation incentivizes telephone companies to upgrade their services to 5G technology, it should be easy for American Tower to increase its profit margins as it increases the number of towers leased to more companies at higher prices. Additional growth in the company’s earnings will hinge on emerging and developing country growth, which should continue in 2018 as shown in Graph 6. Given the current economic externalities and emerging and developing country growth trends, American Tower is a company that might merit a closer look for some investors.

References:

[i] https://www.federalreserve.gov/monetarypolicy/fomcpresconf20151216.htm

[ii] http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

[iii] https://www.nytimes.com/2017/12/14/technology/net-neutrality-repeal-vote.html

[iv] https://www.nytimes.com/2017/11/21/technology/fcc-net-neutrality.html

[v] https://blogs.scientificamerican.com/observations/the-downside-of-net-neutrality/

[vi] https://qz.com/1164158/the-us-dollar-just-had-its-worst-year-in-more-than-a-decade-and-2018-will-bring-more-of-the-same/

[vii] http://www.worldbank.org/en/news/press-release/2018/01/09/global-economy-to-edge-up-to-3-1-percent-in-2018-but-future-potential-growth-a-concern

[viii] http://www.americantower.com/Assets/uploads/files/PDFs/vendor-relations/investor-relations/2016/AMT%20International%20Overview.pdf

Prices of the largest and most diversified U.S. equity index known as the S&P500 continue to increase faster relative to company earnings, leading to an overvalued U.S. market. The problem is what to do next.

Graph 1

If the trend in graph 1 continues, the chances of a market correction will continue to increase, and if a correction occurs, investors will lose value on their investments. The biggest problem with corrections is that investors holding the most stable companies with the best fundamentals tend to be driven down along with the market. This type of risk is known as systemic risk. Although this presents a buying opportunity, it could also mean taking considerable losses for other investors.

Graph 2

Figure 1

Running for Cover

To avoid this problem, many money managers have already started to shift their investments to European markets. However, this will not necessarily lead to investment outperformance due to the positive correlation of U.S. and European markets in the past year as shown in graph 2. Even more worrisome is the fact that the chance of another European crisis is very high[i], which could eat away at investment returns. More importantly, volatility lowers the risk-to-reward ratios, such as the Historical Sharpe ratio, as shown in Figure 1.

Emerging Markets

One asset class that has the potential to outperform the S&P500 over the next few years is known as the emerging market economy (EME). Regrettably, there are a limited number of emerging economies that can be accessed by the average investor.  The best way to invest in these markets recently has been through equity traded funds (ETFs). These ETFs provide opportunities to investors that would like to invest in a single asset group. In the case of emerging markets, ETFs can offer low-expense ratios that are relative to actively-managed mutual funds. ETFs allow the investor to buy a single financial product that reflects the economic growth of a single country and that is composed of different industries (utilities, financials, industrials, etc.).

Graph 3

Unfortunately, many emerging market ETFs have been underperforming over the past few years due to the low commodity prices. Even worse, many emerging market economies suffer from being overdependent on one or more commodities. For example, Nigeria is highly dependent on the price of oil for its economic growth. This over-dependence has made ETFs specializing in single commodities popular with investors, but if this is the case, investing in a single commodity may be the smarter move. Graph 3 shows that the Brent Crude Oil Spot Price correlates strongly with the Global X MSCI Nigeria ETF price. As a result, if the goal is to outperform the market on a risk-to-reward basis, single commodity country dependent ETFs may not be the best choice if the ETF fails to offer diversification among various industries.

The right emerging market ETF would need to have a significant chance at being positively impacted by near future events. It would also have to be diversified enough to have a significant chance of outperforming the S&P500 on a risk-to-reward basis. More importantly, the ETF would need to serve as a hedge against S&P500 systemic risk.

Graph 4

China

Since the end of 2015, Graph 4 shows that industrial metals such as zinc and copper have signs of recovery[ii]. As the biggest consumer of industrial metals, this recovery has been driven by Chinese investment in their infrastructure. This spur in demand should continue to increase this year as the Chinese party will inaugurate its 19th National Congress party in October[iii]. Historically, change in leadership can create political upheaval within the Chinese party, which is why investors expect the Chinese government to continue to increase infrastructure spending in the hopes of maintaining political stability. Additionally, China’s infrastructure initiative, “One Belt, One Road” (OBOR), should keep driving up the price of industrial metals such as zinc and copper[iv][v]. The problem with zinc, however, is that China is the largest producer and consumer of zinc in the world. This makes it much harder to profit from this metal without a significant amount of systemic risk. The bottom line is that investing in zinc exposes individuals to China’s production and consumption whims. The result is that investing in zinc would overexpose the investor to China; then, we must look at the biggest producer of copper, Chile.

Chile

Although 60% of Chile’s export is copper, it only drives 20% of its GDP, leaving room for industry diversification[vi]. 63.4% of Chile’s economy is moved by the service sector and 32.4% by industry but only 4% by agriculture[vii]. This is an important fact because economies that are driven by services tend to have a greater elastic labor force. Additionally, Chile’s human capital is much higher than other emerging market countries[ix]. Although the country is politically stable, high tax policies and regulations have started to have an impact on the Chilean economy. Fortunately, this can be reversed given a change in leadership[x].

Sebastian Piñera

In November of this year, Chile will be having elections, and leading the polls is Former President (2010-2014), Sebastian Piñera[xi]. This self-made billionaire and Ph.D. Harvard-trained economist is promising pro-business policies and double digit growth if he wins the presidency[xii]. He argues that the Chilean economy is in trouble, not because of fundamentals, but because of over-taxation and over-regulatory policies originated by the current president, Michelle Bachelet[xiii].

Donald Trump

A tax plan, that would include infrastructure spending in the U.S. could also drive up the price of copper, which should positively influence the Chilean economy[xiv]. Although a bill has not been presented to the Senate yet, House Representative Paul Ryan assured that a bill would be introduced before August of this year[xv]. In another interview, Treasury Secretary, Steven Mnuchin stated that an infrastructure bill should be signed by the end of this year[xvi]. During the presidential election, Donald Trump promised that one of his biggest priorities would be a one-trillion-dollar infrastructure bill[xvii]. If this bill is passed, it could spur a copper rally as investors speculate on the future price of copper.

Graph 5

Copper and the USD

Graph 5 shows that copper tends to have an inverse relationship with the USD, which serves as a hedge against inflation for U.S. investors[xviii]. Although many metals, including gold, generally hold this inverse relationship, few commodities will be influenced in the next couple of years by many political and economic variables such as copper. If this inverse relationship stays constant, a decline in the USD could be good news for copper.

International Capital Asset Pricing Model

The most popular ETF with exposure to the Chilean economy is called I-shares MSCI Chile Capped[xix] (ticker symbol: ECH). Before analyzing ECH, we can use a version of an old finance model to figure out whether we should look into this ETF further. The international CAPM model can serve as a quick benchmark before spending too much time looking into the potential foreign investment.

Figure 2

Figure 3

Figure 4

Using Ishares Core S&P500 (ticker symbol: IVV) as the benchmark:

Using 10-year bonds for the U.S. and Chile:

We get the following:

5.97% represents the minimum yield that we need to consider this investment.

Graph 6

Assuming a best case scenario of $79 per share for ECH, from Graph 6, we can calculate the holding period yield (HPY):

Figure 5

Because 79.54% is greater than 5.97%, and given the economic and political events taking place in the near future affecting copper and Chile, we can consider taking a closer look at ECH.

Treynor Measure

Looking at the three-month Treynor measure, we can see that ECH is becoming a good hedge against IVV.

Figure 6

Using ten-year bonds as our risk-free rate, we can calculate the three-month Treynor measure for ECH:

Now we can compare this Treynor measure to IVV:

Since the goal is to hedge against systemic risk from the S&P500, a negative Treynor measure due to a negative beta means that ECH has outperformed IVV on a risk-to-reward basis for the past three months[xx]. Although this is only one measure of risk-to-reward performance, ECH currently seems to be performing as a hedge against IVV.

Price Multiples

Looking into ECHs’ biggest sectors, utilities represent 26.6% of this ETF while financials represent 19.95%. Recently, a bill was introduced to the Chilean Congress proposing the adoption of Basel III[xxi] Rules, which should give the Chilean financial sector access to more capital by reducing sector risk if the bill is passed into law. One of the biggest financial holdings of ECH is Banco Santander Chile (ticker symbol: BASC), which accounts for 6.54% of this ETF. Using price multiples, we can find if this bank is correctly valued.

Using the 10-year average PE Method:

Figure 7

Using the current PS Method:

Figure 8

We can find our Historical Multiple Valuation Method using the PE and PS Method:

Figure 9

Because the current price of BASC is currently $25.53[xxii], we can see, using the PE and PS method, that historical-multiple valuations indicate that Banco Santander Chile is approximately 12.8% undervalued.

Graph 6

Given the market and economic conditions in the U.S., and the market correlation with European markets, ECH proposes a diversified alternative, given the global events taking place in the near future, to outperform the S&P500 on a risk-to-reward basis. The biggest drivers of this ETF currently seem to be dependent on future Chinese infrastructure investment, the upcoming Chilean elections, Donald Trump’s infrastructure plan, and the ability of Chilean banks to attract more capital, assuming they adopt new banking regulatory standards. This does not mean that you should invest in ECH but that some risk-to-reward measures indicate that investors looking to outperform the S&P500 on a risk-to-reward basis should consider looking further into ECH.

[i] https://www.ft.com/content/8fe6f7b6-5687-11e7-80b6-9bfa4c1f83d2

[ii] http://www.mining.com/copper-lead-zinc-prices-stay-boil/

[iii] https://www.ft.com/content/cca9dd28-20de-11e7-a454-ab04428977f9

[iv] http://www.mining.com/copper-best-performing-commodity-2017-analysts/

[v] http://www.cnbc.com/2017/05/22/one-belt-one-road-why-the-real-value-of-chinas-project-could-like-in-soft-power.html

[vi] http://www.economist.com/news/business/21576714-mining-industry-has-enriched-chile-its-future-precarious-copper-solution

[vii] https://www.cia.gov/library/publications/the-world-factbook/geos/ci.html

[viii] http://reports.weforum.org/human-capital-report-2015/report-highlights/

[ix] http://reports.weforum.org/human-capital-report-2015/report-highlights/

[x] https://www.ft.com/content/6e681350-2378-11e7-a34a-538b4cb30025

[xi] http://www.reuters.com/article/us-chile-politics-left-idUSKBN16T27J

[xii] https://www.forbes.com/profile/sebastian-pinera/

[xiii] http://www.emol.com/noticias/Economia/2017/05/03/856663/Sebastian-Pinera-propone-bajar-el-impuesto-a-las-empresas-y-crear-cuerpo-colegiado-en-el-SII.html

[xiv] http://thehill.com/policy/finance/330430-trump-tax-plan-likely-to-include-infrastructure-spending-report

[xv] http://www.newsmax.com/Newsfront/paul-ryan-tax-reform-long/2017/04/19/id/785320/

[xvi] http://money.cnn.com/2017/04/20/news/economy/mnuchin-tax-reform/index.html?category=economy

[xvii] http://fortune.com/2017/02/28/trump-congress-address-infrastructure-investment/

[xviii] https://www.thebalance.com/how-the-dollar-impacts-commodity-prices-809294

[xix] https://www.ishares.com/us/products/239618/

[xx] http://investexcel.net/treynor-ratio-excel/

[xxi] http://www.reuters.com/article/us-chile-banks-idUSKBN1932BC

[xxii]  https://finance.yahoo.com/quote/bsac?ltr=1