Author: Sebastiaan Reinders, Lead Portfolio Manager US High Yield at NN Investment Partners
Investors have been on a remarkable ride since Trump’s election in November last year. With equity markets up more than 10% and 10-year Treasury yields up more than 50 basis points since the US election (as of February 10), expectations are high that the new President’s promises will accelerate US growth. Volatility is at extremely low levels and, in our view, is not pricing in many risks that are still present. A lot of uncertainty surrounds the implementation of new legislation, and the policies themselves remain unclear. Given this uncertainty, it is critical to have an active investment strategy with an asset manager who can combine macroeconomic insights with a strong emphasis on bottom-up credit research. Trump’s policies can significantly impact the economic cycle, with varied effects on industry subsectors, as described in more detail below.
Interest rates have moved higher in response to the pro-growth regime and the need to curb inflation. But the impact of higher rates is not entirely positive. Higher borrowing rates will negatively impact highly leveraged companies, increasing interest expense and, over time, defaults. Trump has also prioritized lower corporate and individual tax rates. This tax policy will likely be a positive for financial institutions. Put simply, more money in borrowers’ hands means more money to repay existing loans and/or incur additional loans.
Of course, lower taxes need to be funded from other budget sources. One such source that has been suggested is the removal of interest expense tax deductibility. Much like the impact of higher market borrowing rates noted above, the inability to deduct interest expense for tax purposes would disproportionately hurt highly leveraged companies, which would in turn hurt bank asset quality on the margin. So, lower taxes would be a positive, but funding these reductions could have far-reaching negative repercussions for corporations and financial institutions.
During his first week in office, President Trump named Republican Ajit Pai as chairman of the Federal Communications Commission. Pai is viewed as having a more favorable posture toward industry consolidation than his predecessor, Tom Wheeler. There are several telecom companies that have explored potential combinations but were deterred by the prospect of failing to secure regulatory approval. As a result there is increased speculation of telecom company mergers or interfaith unions between cable and telco companies, which creates investment opportunities.
Increased consolidation could also have negative implications for companies that serve as suppliers to these consolidating entities, such as the tower companies. In addition, companies in the technology space and other sectors are concerned that Trump’s recent immigration ruling and rhetoric on preserving US jobs signal a change in visa policies. Technology companies, including IT consulting companies, often rely on foreign talent. Much of that talent is secured through H-1B visas, which are already in scare supply.
Healthcare also remains a key focal point from a policy standpoint. With Republicans controlling the Presidency, Senate and House, one of the first items on their agenda is the repeal of parts of the Affordable Care Act. Without a 60-vote majority in the Senate, Republicans lack the ability to repeal it in its entirety, but through Executive Order and Reconciliation they can strip out key pieces of the ACA. While Republicans have always postured their plan as “Repeal and Replace”, the key questions remain how and when they will “replace”. This leaves investors with uncertainty and creates investment opportunities for bottom-up credit-focused managers.
We believe that active managers have a big role to play in capitalizing on the opportunities in this uncharted territory. Active managers with a strong focus on credit selection can help investors exploit the benefits, while also avoiding those companies that would be negatively affected in this new environment. Managers that are on top of market cycles can minimize drawdowns and outperform their passive counterparts. We believe that being on top of the bigger macro themes while maintaining a strong emphasis on credit fundamental research will prove to be the winning strategy again in 2017.