Rate Regime Change, Regulatory Relief, and Reduced Tax Rates
by Jeffrey Miller, Partner, Eight Bridges Capital Management
November 19th, 2016
Sometimes the light’s all shinin’ on me,
Other times I can barely see
Lately it occurs to me what a long, strange trip it’s been
The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

In my last note, May the Odds Be Ever in Your Favor, I wrote “The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years.” Since then, the 10 year US Treasury bond has fallen over 3.5%, and the yield has risen over 58 basis points from 1.75% to 2.33% as of the close yesterday.  For investors who bought the 10-year thinking they were going to earn 1.75% for the next ten years, losing over two years’ worth of income in a month must sting a bit. And if they don’t change, they’re going to get stung again.

Rate Regime Change, Regulatory Relief, and Reduced Tax Rates
Source: Investing.com

Could rates pull back a bit?  Sure. It’s been a big move, fast.  But as another writer I respect wrote recently, “Interest rates go from 15% to 1.3%, then go to 2%, and you think you missed it?” Retail investors who have piled into bond alternatives like Utilities and Staples in an ill-informed yield chase are going to be in for a shock when they get their November statements in a few weeks. Long-time readers know that we have been short both sectors via the XLU and XLP for awhile, and those bets have paid off.  We’re not saying the move is done, but the risk-reward is now more balanced, and we’ve been paring them back. (We’re out of the XLP short completely).  One trade we still like is our short in foreign sovereign debt.  This short is working (down 4.7% since election day) and I think will continue to work. Negative interest rate policies are just dumb, as they eviscerate wide swaths of the economy, from pension plans to insurance companies and regular savers. I like being short stupidity, and being short negative yielding bonds is a way to do it.

On the flip side, U.S. banks are on fire. The KBW Regional Bank ETF (KRE) is up 17.1% since election day (full disclosure: I was long XLF and KRE calls before election day and am still long over half the position). Higher rates are only part of the story, and arguably, the least important part. Yes, higher rates are great for most banks, as they can finally earn a spread on their lending. Low rates were terrible for net interest margins (NIM), but with rates moving up, banks can earn a decent return again. This will in turn spur more lending, which will help the economy, particularly small businesses, where funds were tougher to get.  But the big benefit for banks will be in regulatory relief.  Right now, the two big numbers for banks are $10 billion and $50 billion. Not to go into too much detail here, but those are the two asset levels at which onerous fees (particularly at the $10 billion level) and regulations (at the $50 billion level) kick in. There seems to be a general consensus that the Dodd-Frank bill has been overly burdensome on small community banks, with compliance costs through the roof and loan growth to small businesses and individuals (via mortgages) anemic.  A revision or removal of some of the worst of the regulations, particularly for mortgages, will be very beneficial for consumers.  (Bernanke himself had trouble getting a mortgage once he left the Fed – that’s about all you need to know about the state of banking regulations in the U.S.)  Greater mortgage availability will drive home building and construction, which will also benefit the economy overall. (Some will argue that higher rates will crimp mortgage demand due to higher costs. I disagree.  It will crimp refinancing, but whether a mortgage costs 3.5% or 4.0% doesn’t matter much when you can’t get one at either price.  A mortgage you can get at 4.0% is much better than one you can’t get at 3.5%.)

Another big benefit for financial firms? (Arguably the biggest?)  Elizabeth Warren has been sidelined.  The prospect of Senator Warren becoming Treasury Secretary Warren was frightening for financial markets, and was a non-zero probability if Hilary Clinton had won the White House.  The idea of Warren being free to implement her anti-business policies was a frequent topic of conversation among investors I speak with, and now that she is relegated to gadfly instead of policy maker, banks are a much more attractive investment.

Not to be overlooked in a Trump presidency is the prospect for lower corporate tax rates. This is more or less important for some sectors than others (pharma companies and some large international tech companies and manufacturers have been pretty good at reducing their tax rates already), but what sector is pretty tax-inefficient?  Regional banks again.  On average, they pay an effective tax rate of over 33%.  A lower corporate tax rate falls right to their bottom line, boosting 2018 earnings estimates by 10-15% or more depending on the company.  Is most of this already baked into their stock prices after this 17% move?  It sure seems that way.  That said, I think banks have room to move a little higher, probably after a short-term pullback, as the combination of better loan growth, lower regulatory costs, higher interest rates and lower corporate taxes is a powerful tailwind to their earnings growth.

Sittin’ and starin’ out of the hotel window
Got a tip they’re gonna kick the door in again
I’d like to get some sleep before I travel,
But if you got a warrant, I guess you’re gonna come in
          The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

This doesn’t mean that the U.S. stock market is just going to go on a tear. There are lots of companies and sectors that are adversely affected by higher rates or a stronger dollar, or have been a haven in a low-growth, low-rate world. Besides the already discussed staples and utilities getting hammered, stocks that were a safe haven, like FANG (Facebook, Amazon, Netflix and Google) have been weak since election day, as they were a source of funds for investors looking to move into financials.  I’m personally a big fan of Google and am a buyer here, and bought a little Amazon last week for a trade. However, I’d be avoiding companies that get a lot of their income from overseas, as foreign markets are still stagnant at best, particularly in Europe, and the prospect of higher rates and stronger growth in the U.S. is making the dollar stronger every day.  I think we are just at the beginning of a strong dollar regime and that investors that try to fight it will be in a losing trade. Interested in companies that are losers in this batter?  Email me for a free trial of my new StockPicker newletter, where I will be discussing specific stock and sector picks in more detail. 

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