The Trump stock market rally paused last week while bonds continued their post-election sell-off and the dollar its post-election rally. All three major stock market indices lost a little ground with the Dow Jones Industrial Average ending the week at 19,843.41 after trying to hit the completely meaningless 20,000 mark (CNBC had the balloons and buttons ready and may well get to use them), the S&P 500 closing at 2,258.07 and the Nasdaq Composite Index finishing at 5,437.16. In contrast, the yield on the benchmark 10-year Treasury ended the week at 2.6% and the US Dollar Index (DXY) traded as high as 103.56 on Thursday before ending the week at 102.81. Higher yields and a stronger dollar are serious headwinds for US corporate earnings and there is little sign that they will reverse direction any time soon.
Moreover, Trump’s proposed corporate tax cuts may not help as many businesses as people think.
I told you last week that I’d be cherrypicking some long plays during the Trump rally, since it makes no sense to throw perfectly good money down the drain. Today, I want to show you the flip side of the coin.
Here’s why Trump may be bad news for these companies – and how you can profit.
Trump And Yellen Are Teaming Up To Kill Junk Bond Companies
The yahoos in the Marriner Eccles Building actually raised interest rates for the second time in ten years last week. The market decided it didn’t like it on Wednesday, then did like it on Thursday, and then was just bored with the entire affair on Friday. Listening to Janet Yellen at her press conference was not only incredibly boring but also profoundly depressing as it revealed once again that the most powerful central banker in the world not only can barely string two coherent sentences together but also has no clue what is happening in the American economy. Instead, she still thinks the Fed can day-trade the economy back to health when it should be simply getting out of the way.
The problem, of course, is that the Fed waited far too long (at least two years) to start raising rates and the economy is so over-leveraged that normalized rates (i.e. a Federal Funds rate of 2%-2.5%) would cause serious problems for public and private sector borrowers. With the global debt-to-GDP ratio at 235%, the economy will have trouble handling significantly higher rates. On the other hand, low rates are suppressing growth. The global economy can’t grow fast enough to service and repay the more than $200 trillion of debt sitting on its balance sheet. So the world is facing the unhappy choice of having to rid itself of its excess debt by defaulting on some of it (see under Puerto Rico and many states and cities to come like Illinois, Chicago, New Jersey, California as well as many corporations) and inflating the rest away (through traditional inflation or currency debauchment).
Yellen’s higher rates, plus Trump’s proposed tax cuts, are positioned to deal a serious blow to the high yield sector. Here’s why.
Investors should keep in mind that most highly leveraged companies in the junk bond market pay little or no taxes (because they have little or no earnings), so any corporate tax cut coming from the Trump administration won’t help them while higher interest rates will hurt them. Accordingly, the struggle we are going to see in the US corporate sector between lower tax rates and less regulation on the one hand and higher rates and a stronger dollar on the other will deliver different benefits to different companies. But for many leveraged companies, the impact is going to be decidedly negative since the tax cuts won’t have any impact while higher interest rates will be a serious problem. Overall, the impact of the Trump agenda on corporate earnings may end up being only marginally beneficial to US stocks depending on the timing and size of tax cuts, the degree to which interest rates ultimately rise, and the speed at which regulations are cut back.
For investors in bonds, of course, higher rates are an unmitigated disaster. Rates are not only rising in the US; European and Japanese interest rates are sharply higher since the election though still at very low levels. The Japanese bond market is a train wreck and the US market is not far behind. The 10-year yield has basically doubled since its post-Brexit low last August. The most likely path from here is that rates will continue to rise (not necessarily in a straight line but pretty steadily) until they hit a level at which they cause problems for the U.S. economy (i.e. a recession and/or a bad stock market event). Despite all the noise about strong US growth, the reality is that recent US growth has been lousy other than in the third quarter of this year. It is going to take a strong fourth quarter to salvage 2016 as anything other than a terrible year for growth eight years after the end of the financial crisis. Why anybody should expect anything else in the face of higher taxes and mountains of additional business-crushing regulations from the Obama administration is no mystery to me, but apparently it is a complete mystery to the mainstream financial press and the Federal Reserve.
In order to profit, I recommend that you buy puts on the Vanguard Total International Bond ETF (NASDAQ: BNDX) and other high grade bond ETFs. High grade bonds are going to do much worse than high yield – I think high yield is going to be ok for a while despite higher defaults, and I don’t think it is a compelling short. However, investment grade and sovereign debt with very low coupons and long maturities are going to get killed, so I recommend shorting those kinds of ETFs.