The election of Donald Trump has coincided with a sharp rise in interest rates in the US. In fact, the yield on the 10-year Treasury bond has risen from 1.86% on election day (November 8) to 2.22% today. But it’s important to note that the increase in interest rates since the election represents the continuation of a trend that had been in place since early July, when the 10-year yield bottomed out at 1.36%. Prior to that time, lackluster economic data and the recent Brexit vote had created fears of global recession and a belief that central-bank interest-rate hikes would be deferred well into the future. Since July, though, economic data have improved, and the Brexit vote has not caused the dramatic instability that many had feared. In addition, both presidential candidates campaigned on promises of large fiscal-stimulus packages in the form of infrastructure spending. But while both candidates supported infrastructure spending, Trump was the more aggressive of the two. In addition, Trump promised tax cuts for both individuals and corporations as well as tax breaks for companies repatriating cash held overseas. Now that Trump has been elected, investors are betting that the combination of a major infrastructure spending bill and sizable tax cuts will improve aggregate demand, thereby improving growth and ultimately leading to higher inflation. Voila! Higher interest rates.
The ongoing rebound in interest rates from the July lows has been driving a clear rotation out of industry sectors offering high dividend yields and into sectors with better growth prospects. Since July 8, which marked the low for 10-year Treasury yield (1.36%), the worst performing sectors have been Telecom, Real Estate, Utilities and Consumer Staples – all sectors that many investors use to juice portfolio yield. The best-performing sectors, on the other hand, have been those that would benefit most from an acceleration in economic growth. The Industrials, Consumer Discretionary, and Energy sectors all tend to attract capital when growth is heating up, not slowing down. But what about the Financials, which have been the best-performing sector by far since July 8th, putting up at a sizable 18% return over that period?
We have been touting the investment attributes of bank stocks, which are the largest component of the S&P 500 Financials sector, for several months now. Did we do this because we thought Trump would upset Hillary Clinton in the presidential election? Of course not. Our rotation into bank stocks reflected a favorable analysis of the risks and rewards, to include the following points: 1) the downside risk was limited due to cheap valuations and vastly improved balance sheets; 2) an eventual increase in interest rates would be highly accretive to earnings; and 3) unlike many other sectors, the bank stocks offer somewhat of a portfolio hedge against sharply higher interest rates. We covered some of these points in prior market commentaries:
In our July 20th Market Commentary we wrote…
“On the other hand, a rising interest-rate environment should provide long-needed relief for investors in the Financial sector. Higher rates would be a boon for banks that are sitting on piles of cash just waiting to be deployed into higher-yielding assets. As the cash is reinvested, bank profitability should improve dramatically. The improved profitability would benefit bank investors through better earnings growth, higher trading multiples, and increases in dividends.”
In our August 31st Market Commentary we wrote…
“We have been warming to the banks, which are the largest component of the S&P 500 Financials sector, for a few reasons. First, the sector has been, until recently, a rather dramatic underperformer, with the KBW Bank Index trailing the S&P 500 by more than 14% from the end of 2015 through July 30 (that underperformance has since been cut nearly a half). If we combine the sector’s relative underperformance with historically low valuations on a price-to-book value basis, it seems that the risk/reward trade-off is relatively positive. Secondly, banks stand to benefit from rising interest rates as interest earned on their assets will increase more rapidly than interest paid on their dividends – a posture referred to in the banking industry as being “asset sensitive.” And finally, because bank earnings will rise with interest rate increases, bank stocks can offer some portfolio insurance against Fed interest-rate increases. This is important as we have all seen how the market can react to the prospect of Fed rate hikes, from the 2013 “taper tantrum” to the correction very early this year when it appeared that the Fed was ready to hike rates in earnest.”
The chart below shows that the high correlation between bank stocks (we use the KBW bank index as a proxy) and the yield on the 10-year Treasury bond. Bank management teams have been waiting for this moment for years. Aggressive fiscal policy is likely to boost economic growth and demand for loans. Flush with low-cost deposits, the banks can now extend those loans at more attractive spreads. And just to add icing to the cake, Trump’s campaign rhetoric suggests that some of the crippling new bank regulations (Dodd Frank, Volcker Rule) added since the financial crisis might be rolled back. The net result has been a dramatic spike in the bank stocks since the election, on top of the solid gains prior to the election. In fact, the KBW Bank Index has risen 30% since July 8!
We find that too often retail investors forget to incorporate the “risk” part of the “risk/reward analysis.” We clearly didn’t know Trump was going to win on his populist campaign rhetoric. But we also felt like we were at least somewhat protected against a negative outcome, like a long, drawn-out and destabilizing protest against the election results by the losing candidate. Investors need to recognize that beating the market over the LONG-TERM can be done in several ways, including going down less than the market when the market is weak. The added benefit of lower volatility is that it can also help you sleep better at nights. It sure helps us!