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Good morning. Unhedged has decided to tactically tune out of the drama in 10-year US Treasury yields, which fell 9 basis points yesterday, for some reason. Someone will let us know when something important happens. Today, we tune into the drama in US politics, which is only just beginning. Tomorrow’s newsletter will be written by the incorrigible Jenn Hughes. But for now, email us: robert.armstrong@ft.com and ethan.wu@ft.com.
Trump’s second term
We don’t write about politics much at Unhedged, because we don’t have political expertise. We’re just a couple of guys who read the newspaper. But given that recent polls suggest that, if the presidential election were held today, Donald Trump would defeat Joe Biden, we would be remiss not to talk about the market implications of a change in administration. So we will proceed carefully here and — to use a phrase associated with another noted politician — cross the river by feeling for the stones.
To help with the crossing, we spoke with two friends of Unhedged, who both make a living helping Wall Street think about Washington: Ed Mills of Raymond James and Marko Papic of Clocktower Group. We asked them what would be the most important implications for investors should Trump win.
Mills argued that the big implications of Trump II would be:
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The regulatory tightening in banking comes to a halt. Since the banking mini-crisis in March, the move to impose tougher requirements for total capital and long-term debt financing has shifted into high gear. But the implementation, Mills points out, will not be before 2025 — just in time for Trump-appointed regulators to backpedal furiously.
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Uncertain follow-through on the Inflation Reduction Act. Industrial companies that are investing in green energy and upgrades to the power grid need long-term certainty around the tax incentives in the 2023 law. It would require new laws to roll the IRA back, but a Trump administration would probably try it.
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Renewal of the Trump tax cuts for individuals. If Trump wins, and Republicans regain the Senate, renewal of the cuts, which were worth an estimated $1,600 to each US household, is likely. They expire at the end of 2025. If it’s Biden, Mills says, “it’s all up for debate — the corporate rate, top individual tax rate, the state and local tax deduction”. The overall fiscal posture of the US government is up for grabs in this election.
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International investors’ perception of the US as a destination for investment. At Unhedged we have often discussed the premium global investors pay for US assets. Mills sees this as a price paid for political and legal stability. If a second Trump administration makes the political environment more partisan, and policy outcomes less predictable, the premium could shrink.
The three things that will matter most, according to Papic:
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A new level of fiscal profligacy (assuming a Republican Senate and House). Trump is a nationalist and a populist, and will spend and cut taxes without restraint, Papic argues. That will drive inflation expectations up and bond prices down. The only question is whether the bond market starts pricing this in next year or waits until Trump is elected.
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A looser but a less efficient administrative state. “They really mean to drain the swamp this time,” Papic says, and while that “suggests an easier regulatory environment, it also suggests delays, lawsuits, and back and forth — an administrative state that is just slow”.
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Protectionism, whether by tariff or a weak currency. Trump has proposed a tariff of 10 per cent on all imported goods. It will meet domestic and international resistance. But an easier way to achieve the goals of such a tariff — in terms of rebuilding domestic production — is to weaken the dollar. Like Richard Nixon with his proposed import surcharge, Trump may drop his tariff and focus on the exchange rate (possibly by putting political pressure on the Federal Reserve).
The two lists are different but they rhyme: regulatory and fiscal easing, coupled with a dose of uncertainty. One area where the two analysts differ is on the future of the US-China relationship. Mills thinks that relations could worsen, because while Biden has taken strong actions that have impinged on Chinese interests, these actions have been unambiguous and well telegraphed. Trump would be less predictable. Papic disagrees: he thinks that Trump’s strong-on-China reputation is so strong that it gives him room to do a deal with the Chinese, if he sees one that is advantageous to the US.
There is much more to say on this topic. We are very keen to hear readers’ views.
Small-cap balance sheets: eek
Yesterday we expressed a broadly sanguine attitude about higher rates’ impact on corporate balance sheets. There will be rate-led corporate meltdowns — there already have been — but a big contagious conflagration seems unlikely.
That easy attitude may, however, reflect the fact that we focused mostly on large-cap US stocks. Small caps, I have been told, are much more vulnerable. To put this notion to the test, I ran screens (using S&P Capital IQ) of the S&P 500 big-cap and the S&P 600 small-cap indices. I looked at leverage (measured as net debt/ebitda) and interest expense coverage (measured as operating income/interest expense). I excluded financials, for which these ratios tend not to work.
For leverage, I found that in the large-cap ex-financials index, 9 per cent of the companies (39 out of 428) had leverage ratios over 6, a traditional threshold for seriously high debt. For the small caps, the figure was 16 per cent (79 out of 479).
The same pattern appears in interest coverage, but is more extreme. Just 6 per cent of the large caps had interest coverage of less than 1.5 times. For the small caps, it was 19 per cent — and many of those companies had no operating earnings at all.
Screens like these, without context, are just a bunch of numbers. So I called up two people who actually manage small-cap portfolios and asked if I was right to see a lot more rate risk in the small caps.
James Mendelson, who is co-portfolio manager of GMO’s small-cap quality strategy, agrees. “Yes, there is more leverage in small caps,” he says. Not only that, more of the debt is variable rate and more of it matures soon. What is particularly odd is that the most leveraged companies in the small-cap universe have not been penalised particularly severely by the market, even as interest rates have jumped.
Medelson’s team recently split US small caps into quartiles by leverage, and compared the performance of the most and least leveraged quartiles. They found for the 12 months ending in October, total returns in the highly leveraged quartile were only 6 percentage points worse than the least leveraged.
So is the big gap in valuation between big and small caps justified (the S&P 600 is at a discount of nearly 50 per cent to the S&P 600)? Not entirely, according to Mendelson: many small-cap companies are trading cheaply compared with their own history, not just with big caps. But you need to be selective.
“There is a significant percentage of small-cap companies that are in a precarious spot — not just because of leverage but because of the structure of their balance sheets, maturity schedule, and the tightening of lending standards,” says Bryant VanCronkhite, senior portfolio manager at Allspring Global Investments. “A lot of these businesses don’t have the stability of ebitda that large companies have, either, because they don’t have diversity in their products and markets.” There are times, he says, when balance sheet quality and cash flow stability are not that important, but this is not one of them.
“Focusing on leverage and coverage is not good enough. You need to think about maturity schedule, covenant packages, ability to refinance,” VanCronkhite says.
It will be interesting to see whether active small-cap managers can outperform their indices during the transition to a higher-rate world. This is the moment for them to earn their fees.
One good read
If the US Treasury defaults.
