Preferred Securities in a Trump Administration

Flaherty & Crumrine Incorporated

Summary & Conclusions

• We expect economic growth to accelerate modestly under a Trump administration.
• A lower regulatory burden and tax reform could enhance growth, while trade tariffs and too-restrictive immigration policies could detract from it. Higher budget deficits are also a longer-term threat.
• The U.S. economy still faces constraints that will take a long time to resolve; while growth can improve, it’s unlikely to jump to a new, higher plateau. Likewise, inflation should accelerate only modestly.
• After rising about 75 basis points (bp) since late summer, benchmark interest rates are now broadly in-line with modestly stronger economic growth and three 25 bp Fed rate hikes likely between now and year-end 2017.
• Stronger economic growth and regulatory reform should benefit financial companies, which are the primary issuers of preferred securities.
• Duration fears over preferred securities appear exaggerated; we believe they are attractive at current prices.
• Active management may be particularly valuable in changing market conditions.

Analysis

Fixed income assets, including preferred securities, have sold off substantially since Donald Trump’s surprise election on November 8th. There are some good – and some not so good – reasons for this. We will describe and give our thoughts on some of them and how they may affect preferred securities over coming quarters.

We’ll start with a general observation. Republican control of the White House, House of Representatives and Senate (albeit with a razor-slim majority there) is almost certain to shift policy back toward the center after a government-centric turn over the past eight years. A better balance between public and private sectors could improve prospects for economic growth. To the degree that economic growth is responsible for much of the political malaise in the U.S., progress on raising long-term economic growth is vital.

Policies highlighted by President-elect Trump that could benefit economic growth include:

• A reduced regulatory burden on businesses would improve productivity. Although most regulations will (and should) remain intact, many can be better-targeted, and some of them can be eliminated entirely. Regulations typically increase cost without increasing output1. A lighter regulatory burden should lower cost without reducing output and, thus, raise productivity, which should drive stronger economic growth.
• The banking, insurance and utility industries are particularly heavily regulated, and some regulatory relief could improve profitability at these large issuers of preferred securities. That would provide an additional margin of safety for preferred securities, since profit is the first defense against losses.
• Tax reform could improve economic efficiency. There are too many competing proposals to know what shape tax reform might take, but if the final plan lowers rates and narrows deductions (i.e. broadens the tax base), then it should improve economic efficiency, lower tax compliance costs and promote economic growth at whatever tax rates are enacted.

Mr. Trump also campaigned on policies that could dampen economic growth, including:

• Tariffs and trade restrictions could raise inflation. Although renegotiating existing trade agreements (better deals are possible) and better enforcement of existing agreements may be desirable, tariffs are almost always bad economic policy. Tariffs or other restrictions raise costs to consumers, increase inflation and, thus, lower living standards. In addition, they typically result in retaliation from countries affected by them, which would lower U.S. exports, employment and income. In short, they may be good political theater, but they generally are bad economic policy. That’s particularly true today since the U.S. economy relies on a global supply chain, often with few domestic alternatives.
• Restricting immigration could slow economic growth. The U.S. birth rate is low, its population is aging, medical care costs are rising, and entitlement costs (largely tied the latter two trends) are growing faster than the economy. Absent an unlikely surge in the U.S. birth rate, the U.S. population (before immigration) is projected to begin shrinking within a generation. As Japan’s experience has shown, it’s very difficult to generate economic growth without a growing population. The U.S. is going to need immigration to sustain labor force growth. The trick is to better match those we admit with labor demand (particularly in areas where there are clear labor shortages), which should enhance both growth and social stability. However, immigration is the only answer to labor force growth over the short run since structural reforms aimed at reducing labor imbalances (mainly regulatory and educational) could take a long time to bear fruit. And unless the birth rate picks up, the U.S. needs immigration over the long run too. Although immigration reform could benefit growth if done right, there’s a lot of room to get it wrong.
• Wider budget deficits could raise interest rates and slow economic growth. Higher deficits are likely regardless of policy choices due to rapidly-rising entitlement spending. The U.S. has some room left (in terms of debt-to-GDP) for wider deficits, but it’s limited. If tax cuts are too deep or fiscal stimulus spending too large, higher interest rates could offset much of the positive impact of those programs. We think fiscal hawks in Congress would reject policies that widen the deficit dramatically, but the Treasury market is pricing in risk of a bad outcome.

And finally, a policy of Mr. Trump in the “it could-be-good or could-be-bad” category:

• Infrastructure spending could be good, bad or neutral; it all depends on where the money is spent. While it’s widely recognized that U.S. infrastructure is decaying, it’s less clear what should be replaced, improved, patched, or scrapped. Politicians naturally want to earmark money for their districts, whether it’s needed or not. Even when well-intentioned, infrastructure spending lacks price signals, so it’s difficult to discern which projects are most needed. Thus, a lot (politically-directed) infrastructure spending generates low or even negative returns, while every dollar of it would need to be deficit-financed. Mr. Trump aims to avoid those pitfalls through public-private partnerships, though it’s unclear what form those would take or if they might create other problems. A small infrastructure program that finds its way to worthy projects could be a benefit, but a massive 2009-style “shovel-ready” stimulus program probably would mostly add to the deficit and have little to show for it.

Adding it up, we see a lot of low-hanging fruit in tax and regulatory reform that could boost growth without adding a lot to the deficit – and that could help to narrow it over time if faster growth takes hold. There is risk on trade and immigration policy, but there are also paths toward better policy on both. And as long as infrastructure spending is not too large, it probably will not do too much harm and could do some good. Economic prospects are now more uncertain, but we think likely outcomes, on balance, are reasonably good.

At the same time, we think most of these policies are likely to affect economic growth – and, thus, monetary policy – only at the margin. The U.S. economy still faces constraints from slowing population growth, an aging workforce, poor educational outcomes for many citizens and sluggish productivity growth, none of which can change very quickly regardless of economic policy. Some of the policies outlined above could improve productivity and growth, and others could detract from them. Moreover, global economic growth remains challenged, and excess capacity both in the U.S. and abroad limits potential returns on U.S. investment in many industries.

We think U.S. inflation-adjusted gross domestic product (real GDP) growth will accelerate from an average of 2% since 2011 to 2.0-2.5% over the next several years, but we do not foresee the U.S. economy leaping to a higher-growth plateau. Yes, real GDP grew by 2.9% in the third quarter of this year (and it’s likely to be revised up from there), but that’s after an average of 1.1% growth in the first half. Slightly faster growth and slightly higher inflation should prompt the Federal Reserve to tighten monetary policy by 25 bp in December 2016 (now fully priced-in), June 2017, and December 2017.

As we argued in our latest U.S. Economic Update, we expected higher interest rates in the U.S., although we have been surprised by how quickly they adjusted.3 After their recent selloff, we think U.S. Treasury rates are roughly in-line with the pace of economic growth and Federal Reserve tightening that we expect for 2017. Continued growth will push rates gradually higher, but with downside risks still present, we think most of the near-term adjustment in rates has already happened. At the same time, yield spreads on preferred securities remain relatively wide. Credit fundamentals are good, and judging by performance of common stocks since the election, investors anticipate substantial improvement in the profits of financial companies, which should lead to narrower yield spreads on preferred securities. Nevertheless, investors should expect preferred yields to remain volatile as policies are unveiled and enacted.

Finally, many preferred securities are no longer the long-duration instruments they once were. Flaherty & Crumrine’s portfolios are comprised mostly of fixed-to-floating rate preferred securities. These securities have a fixed-rate period for an initial period, typically 5-10 years, and then float off an interest-rate index, at which point they have minimal interest-rate duration. As a result, they have intermediate duration – with about the same sensitivity to Treasury rates as a 5-year Treasury note, which shortens as they approach their floating-rate dates.4 At the same time, they earn relatively high yields. This combination of high yield and moderate duration means that when Treasury rates rise while credit spreads are about steady, it typically takes less than a year to recoup even a 100 bp rise in rates.

It would have been prescient to sidestep the recent 75 bp rise in intermediate Treasury rates since late summer. Having absorbed it, we do not see another sharp Treasury selloff occurring near-term, while we do see credit prospects improving, especially for financial companies. Moreover, opportunities to reinvest income and redemption proceeds have improved substantially over the past several months. Accordingly, we think preferred securities are attractive at current prices. Active management may be particularly valuable during the changing market conditions ahead.

1 For example, regulatory compliance at financial institutions requires sizable information-gathering and analytic systems and compliance staffs to run them. Those people and systems raise expenses, but they do not make new loans or otherwise add to revenue. They may provide ancillary benefits to an institution and society (including possibly reducing risk of future crises), but they lower productivity, at least over the short run.

2 Source: United Nations, World Population Prospects, Zero-Immigration Scenario, 2015.

3 Third-Quarter U.S. Economic Update, Flaherty & Crumrine Incorporated, November 7, 2016.

4 Fixed-to-floating rate securities have high credit duration (i.e., price sensitivity to changes in option-adjusted credit spreads, holding Treasury rates constant), but generally have intermediate interest-rate duration (price sensitivity to changes in Treasury rates, holding option-adjusted credit spreads constant).