Trump and portfolio impacts

[rb]

Banks and insurance are still cheap relative to their historical valuations and the market, even after the recent bump.  Plus, they've been hated for almost a decade now and have the tailwind of rising rates for reinvestment of bonds or loaning to customers.  I see them as a great multi-year hold at this time and would expect many of them to have large gains (doubles, etc) over that period.

 

Hi, can any of you please compare banks vs. insurance in a rising rate environment? Similarities and differences?

 

Thanks.

Seriously?! Couldn't you have asked a simple question like is there life after death or something?

 

Ok I'll give it a shot and try to do my best in one post. But the issues are more complex than I'll portray. Let's start with insurance cos cause they're more simple imo.

 

So insurance profits are the sum of underwriting and investment income. Insurance demand is not that volatile so underwriting profits are driven mainly by industry supply rather than demand. The second part is investment. Underwriting generates float which gets invested - mainly in bonds. In a dropping interest rate environment profits tend to be artificially high as they're collecting higher than market interest and also scoring mark to market gains on their bond portfolio. Their future investment income will decrease as they replace high interest bonds with lower interest ones.

 

In a rising interest rate environment the insurance co's profitability will be understated because they're collecting lower interest rates on their legacy bond positions and also taking mark to market losses but profitability will increase as the replace lower interest bonds with higher interest ones.

 

For banks the story is more complicated because there are a lot more moving parts. It requires a lot of understanding between economics, inflation and interest rates and their causes. Those 3 interact each other a lot. Banks make their money of net interest margin - the difference between interest collected off loans and interest paid on loans. Generally net margin is quite stable. Also generally lower interest rates are better for banks because you get higher volume due to lower price. Conversely higher interest rats are bad - because higher prices -> lower volume.

 

However in banking weird stuff starts to happen as you approach zero interest rates. At that point it's a high liquidity environment so your Net interest margin gets compressed because the interest you can charge gets compressed by too much supply and you can lower the rate you pay for deposits (this is an evolving theory in the era of negative rates). At the same time your volumes collapse because you didn't get to zero rates by accident. You got there because of a severe economic crisis that triggered a deflationary and deleveraging cycle.

 

When you're a bank in a zero rate situation, rising rates are very profitable because you get hit with the reverse double whammy: higher net interest margins and higher volumes. But these have to be naturally rising rates. They have to be going up because of a a strong economic recovery that's pushing inflation higher which results in higher rates to calm inflation. It can't be cause some idiot called for higher rates on TV for whatever reason and some bigger idiot at the Fed implemented them. At that point you get disaster.

 

This is not a complete post by far but I hope it at least sheds some light and somewhat answers your question.

[petec]

I think you framing of interest rate changes is missing something.  What is important is not the absolute changes in rates but the relative change.  Values will double if rates go from 12% to 6% or 3% to 1.5%.  The other thing about interest rates is they do not mean revert they go up and down over long period of times in waves.  The current cycle began in 1980 so it is 36 years old.  The last two long term cycles were about 80 years in duration.  The Victorian deflation ran from 1820 to 1900 and the Great Reflation from 1900 to 1980.  These are described in The Great Wave.  So we are about half way through this cycle so comparing PEs now to 1980 is comparing apples & oranges as the interest rates environment is completely different.

 

As to increased demand I think that what is missed is where will the wealthy savings go?  Will it go to bonds that yield 1 or 2% or stocks that yield more? I think stocks. 

 

As to corporate tax rates in most studies I have seen the effective rates range from 25 to 30% averaging around 27%.  So I think the drop will be 10%+.  As to retiring the Navy, I would not put a massive cut back on overseas deployment as out of the range of possibility & a resulting decline in the defense budget. 

 

I think these are some of the reasons Fairfax has become more bullish.  You are correct that valuation is high compared to history since 1980 but the underlying assumption is you are expecting interest rates to be the same to make the comparison valid.  I do not think the 1980s interest rates will return for a long time so I use the ERP to gauge equity valuations versus P/Es which include both interest rate and ERP forecasts.

 

Packer     

 

Packer and rb, thanks for an interesting discussion.  I'm inclined to agree with both of you, which is uncomfortable ;) 

 

Packer, while I take the point that rates are likely to stay low for a while yet, does The Great Wave give any reason for an 80-year (or rather a 160-year) cycle?  We have only had one full cycle: that does not seem to me to be enough to call the average length of a cycle with *any* certainty.  Also, that one cycle was on the gold standard; the new one is fiat.  That could alter timelines drastically.

 

 

[JBTC]

Banks and insurance are still cheap relative to their historical valuations and the market, even after the recent bump.  Plus, they've been hated for almost a decade now and have the tailwind of rising rates for reinvestment of bonds or loaning to customers.  I see them as a great multi-year hold at this time and would expect many of them to have large gains (doubles, etc) over that period.

 

Hi, can any of you please compare banks vs. insurance in a rising rate environment? Similarities and differences?

 

Thanks.

So insurance profits are the sum of underwriting and investment income. Insurance demand is not that volatile so underwriting profits are driven mainly by industry supply rather than demand. The second part is investment. Underwriting generates float which gets invested - mainly in bonds. In a dropping interest rate environment profits tend to be artificially high as they're collecting higher than market interest and also scoring mark to market gains on their bond portfolio. Their future investment income will decrease as they replace high interest bonds with lower interest ones.

 

In a rising interest rate environment the insurance co's profitability will be understated because they're collecting lower interest rates on their legacy bond positions and also taking mark to market losses but profitability will increase as the replace lower interest bonds with higher interest ones.

 

 

Thanks very much rb.

 

So if we leave the underwriting side of the insurance business aside, is the investment side of insurance similar to a bond fund (with a small amount of equity)? And if that's the case, how can rising rates be good for insurance? I suppose one factor is how fast the float grows, which will be invested at higher yields and partly offset the decline in the value of the bond portfolio.

 

I asked the question with MKL in mind - it has done very well in the past due in part to strong returns from its equity and bond portfolios. Does a rising rate environment mean that its past returns simply cannot be repeated?

 

[rawraw]

For banks the story is more complicated because there are a lot more moving parts. It requires a lot of understanding between economics, inflation and interest rates and their causes. Those 3 interact each other a lot. Banks make their money of net interest margin - the difference between interest collected off loans and interest paid on loans. Generally net margin is quite stable. Also generally lower interest rates are better for banks because you get higher volume due to lower price. Conversely higher interest rats are bad - because higher prices -> lower volume.

 

 

I'm not so sure I agree/understand with the above bolded statements.  No idea what volume you are talking about.

 

Also, while it seems many investors pay attention to the level of interest rates for banks.  The shape of the yield curve is equally very important.  Banks do better not necessarily when rates are low or high, but rather when the spread between borrowing and lending rates are wide.

 

In terms bank complexity with rising rates, the problem is that the financial assets and liabilities are the reflection of consumer behaviors.  One easy example is what happens to money supply may impact deposit composition.  So unlike a portfolio of bonds with more-or-less contractual behaviors, you have customers often under no contract on the liability side.  And on the asset side, you may have loans that reprice with rates -- but when rates start to rise, borrowers could easily then switch to fixed rate loans.  The bank is faced with losing the customer to another bank willing to make the fixed rate loan or do it themselves.  These little behavior changes occur all over the bank's balance sheet.  So all else equal, I think it is a little harder to model the bank's actual change in income from higher rates.

 

I'm not very familiar with insurance.  But bond portfolios of banks benefit from rising rates if they produce a lot of cash flows in the interim periods of principal / interest.  As a result, different companies can structure investment portfolios differently based on their desire for volatility in earnings around changing rates.  I assume insurance is similar

[Packer16]

The Great Wave documents four of these cycles going back to 1200.  What is interesting about the gold standard is that as a result of better mining techniques in the 1800s the gold supply increased 5x from 1820 to 1860 yet prices declined by about 30% over that period.  What this tells me is that deflation is a caused by excess capital that created in boom and not destroyed by war, famine or epidemic.  What the book chronicles is the historical waves of capital creation as shown by excess food supplies, goods and services and the technological innovation which creates these surpluses offset by war, famine and epidemic which destroys capital created in the previous creation period.  The main difference today is the war, famine and epidemic portion of the cycle has been reduced so you have excess capital being created around the world.  What is offsetting price declines is the fiat money being printed so nominal deflation is avoided.

 

Packer

[whiterose]

So if we leave the underwriting side of the insurance business aside, is the investment side of insurance similar to a bond fund (with a small amount of equity)? And if that's the case, how can rising rates be good for insurance? I suppose one factor is how fast the float grows, which will be invested at higher yields and partly offset the decline in the value of the bond portfolio.

 

From what I understand about the insurance industry, this is basically correct. But unlike a bond-fund, the fixed income securities are held to maturity (if you have prudent management) to match future liabilities. So even when in a falling rate environment you get some unrealized gains in comprehensive income (mark-to-market), they will not be realized or paid out ("virtual" gains). In a rising rate env. you have the opposite: falling mark-to-market prices but no realized losses. On the other hand, in the meantime the new float can be invested in higher yielding bonds. So all in all a net-positive on the investment-side, if prudently managed. But I'm not an expert.

[JBTC]

So if we leave the underwriting side of the insurance business aside, is the investment side of insurance similar to a bond fund (with a small amount of equity)? And if that's the case, how can rising rates be good for insurance? I suppose one factor is how fast the float grows, which will be invested at higher yields and partly offset the decline in the value of the bond portfolio.

 

From what I understand about the insurance industry, this is basically correct. But unlike a bond-fund, the fixed income securities are held to maturity (if you have prudent management) to match future liabilities. So even when in a falling rate environment you get some unrealized gains in comprehensive income (mark-to-market), they will not be realized or paid out ("virtual" gains). In a rising rate env. you have the opposite: falling mark-to-market prices but no realized losses. On the other hand, in the meantime the new float can be invested in higher yielding bonds. So all in all a net-positive on the investment-side, if prudently managed. But I'm not an expert.

 

Thanks.

 

In terms of the balance of the two offsetting factors, how do we know if it's going to be a net positive or a net negative?

 

I suppose whether the bonds are held to maturity or not doesn't really change the economic outcome.

 

[whiterose]

I suppose whether the bonds are held to maturity or not doesn't really change the economic outcome.

 

It does, when you don't (have to) sell below par, there is no economic loss. Only opportunity cost, but in the real world you have to make decisions under uncertainty and holding to maturity is the best approach I guess. Some insurance-investment-managers may trade around their positions, but in a theoretical simplified world, the "virtual gains" from the past were non-existent just like the future "virtual losses" are not really there. It's all about the incoming interest payments, which will rise over time, it seems. It should be a continuous lagged process.

[onyx1]

Jeff Gundlach:

 

"Look for Trump to "amp up the deficit" to pay for infrastructure and other programs - producing an inflation rate of 3% and nominal GDP growth of 4-6%. Given that, there's no way the 10-year Treasury yield stays near its current level of 2.15%, and it could rise as high as 6% in the next four or five years."

 

Hard for me to imagine this scenario is anything but super-positive for bank earnings.

[petec]

Jeff Gundlach:

 

"Look for Trump to "amp up the deficit" to pay for infrastructure and other programs - producing an inflation rate of 3% and nominal GDP growth of 4-6%. Given that, there's no way the 10-year Treasury yield stays near its current level of 2.15%, and it could rise as high as 6% in the next four or five years."

 

Hard for me to imagine this scenario is anything but super-positive for bank earnings.

 

Do you think the economy could withstand 6% rates?  Do you think the Fed would let that happen? 

 

Federal debt interest expense would be something to see under that scenario!

[petec]

So if we leave the underwriting side of the insurance business aside, is the investment side of insurance similar to a bond fund (with a small amount of equity)? And if that's the case, how can rising rates be good for insurance?

 

Short term bonds roll onto higher yields.  Pricing gets easier in an inflationary environment.  (This is a double-edged sword since claims also rise, but FFH's work suggests that insurecos really struggle in deflations so on balance, inflation is better).

[onyx1]

Jeff Gundlach:

 

"Look for Trump to "amp up the deficit" to pay for infrastructure and other programs - producing an inflation rate of 3% and nominal GDP growth of 4-6%. Given that, there's no way the 10-year Treasury yield stays near its current level of 2.15%, and it could rise as high as 6% in the next four or five years."

 

Hard for me to imagine this scenario is anything but super-positive for bank earnings.

 

Do you think the economy could withstand 6% rates?  Do you think the Fed would let that happen? 

 

Federal debt interest expense would be something to see under that scenario!

 

 

I can only generalize because the world is way to complicated for me to predict.

 

I believe excessive regulation and high taxes have put a "wet blanket" over the country and smothered growth prospects.  In order to maintain any growth at all, Washington has used the one tool they have complete control over: the Fed. 

 

Remove the "wet blanket" and growth will naturally rise as will interest rates.

 

Banks should be at the front of the line to receive the benefits.

 

Will this scenario play out?  I really don't know, but it sounds plausible and since I own BAC and WFC I'll be watching closely.

[InspireByReason]

Everything you guys are discussing is way over my head. Does anyone have a starting point to understanding the effects of rates/inflation/deflation on the economy?

[rb]

I suppose whether the bonds are held to maturity or not doesn't really change the economic outcome.

 

It does, when you don't (have to) sell below par, there is no economic loss. Only opportunity cost, but in the real world you have to make decisions under uncertainty and holding to maturity is the best approach I guess. Some insurance-investment-managers may trade around their positions, but in a theoretical simplified world, the "virtual gains" from the past were non-existent just like the future "virtual losses" are not really there. It's all about the incoming interest payments, which will rise over time, it seems. It should be a continuous lagged process.

There's also another thing. Normally the interest rate environment isn't that big of a deal for insurance cos when you deal with a normal yield curve. They usually buy long term bonds. While short term rates can be quite volatile, long term rates tend to be a lot more stable. But we're not not living in normal times and when you hit zero rates the yield curve flattens against that zero bound and that's not good for insurance cos.

[rb]

Jeff Gundlach:

 

"Look for Trump to "amp up the deficit" to pay for infrastructure and other programs - producing an inflation rate of 3% and nominal GDP growth of 4-6%. Given that, there's no way the 10-year Treasury yield stays near its current level of 2.15%, and it could rise as high as 6% in the next four or five years."

 

Hard for me to imagine this scenario is anything but super-positive for bank earnings.

So when you had a depressed economy with a lot of slack, high unemployment, zero interest rates, QE, and a Democrat government who wanted to pass some much needed stimulus all these guys were running around with their hair on fire yelling that Keynesian policies were Socialism and were gonna destroy America, future generations, and the space time continuum.

 

Now you have a recovering economy, with much lower unemployment, much lower slack, with tightening labor markets where wage growth is starting to get some traction, and interest rates are starting to go up. Two days after the Republicans win the election Keynesian policies are the greatest thing since sliced bread.

 

Funny how that works.

[bbarberayr]

When life insurance companies write a policy, they try and match, in aggregate, the corresponding investments.  The they just sit on the investment and use it to pay out the claims at the end.  This works great if you are selling insurance to older people, but, of course, younger people will live far longer than the longest bonds you can buy.  So insurance companies have what they call reinvestment risk that the rates when a bond comes due is lower than the rate on the bond which matures. 

 

On the other side, in a rising rate environment, they can reinvest the bond at a higher rate and generate more profits.  That is what looks to be happening now.  The risk for insurers is that rates rise too quickly, and then new policies, with higher rate assumptions, can be written much more cheaply than the older policies, causing people to cancel and rebuy insurance.  The insurer is then stuck with low-rate bonds and will incur a capital loss if forced to sell early.

 

But in general, if you look at the SEC filings, some insurers will tell you their expected yield to maturity on their bond portfolios.  They mostly hold corporate bonds, not government, but these yields have gone from the 5.7% range to the 4.1% range, so you can see the hit on earnings, especially when you consider how large the bond portfolio is relative to the equity of the company.  Also, the capital gains on their bonds due to falling rates are  not recognized by the market and you see them valued on book less AOCI (Accumulated other comprehensive income - this includes capital gains).  So, as rates rise, AOCI will fall, but won't affect stock prices much and income from new bonds will rise increasing earnings.

[Jurgis]

So when you had a depressed economy with a lot of slack, high unemployment, zero interest rates, QE, and a Democrat government who wanted to pass some much needed stimulus all these guys were running around with their hair on fire yelling that Keynesian policies were Socialism and were gonna destroy America, future generations, and the space time continuum.

 

Now you have a recovering economy, with much lower unemployment, much lower slack, with tightening labor markets where wage growth is starting to get some traction, and interest rates are starting to go up. Two days after the Republicans win the election Keynesian policies are the greatest thing since sliced bread.

 

Funny how that works.

 

Yep.

[CorpRaider]

$10 says the "freedom caucus" won't think it is so great.  But Trump can probably steamroll them.

[Jurgis]

$10 says the "freedom caucus" won't think it is so great.  But Trump can probably steamroll them.

 

You're likely right in your first sentence. We don't know about your second sentence: it's still not clear who will do what when push comes to Congress. Will Dems work with Trump and some part of Reps? Will all Reps work with Trump? Will Trump be (mostly?) sidelined by Reps? Will he propose and work to push through bills that have a chance to be voted for? Lot's of questions, but not many answers yet. IMO even the transition team composition and Rep/Dem pre-posturing don't answer most. We'll just have to wait and see.

 

(And IMO market euphoria is too early. But I guess it's one of Mr. Market being optimistic moments.)

[rb]

$10 says the "freedom caucus" won't think it is so great.  But Trump can probably steamroll them.

I'll take the bet.

[Spekulatius]

I think you framing of interest rate changes is missing something.  What is important is not the absolute changes in rates but the relative change.  Values will double if rates go from 12% to 6% or 3% to 1.5%.  The other thing about interest rates is they do not mean revert they go up and down over long period of times in waves.  The current cycle began in 1980 so it is 36 years old.  The last two long term cycles were about 80 years in duration.  The Victorian deflation ran from 1820 to 1900 and the Great Reflation from 1900 to 1980.  These are described in The Great Wave.  So we are about half way through this cycle so comparing PEs now to 1980 is comparing apples & oranges as the interest rates environment is completely different.

 

As to increased demand I think that what is missed is where will the wealthy savings go?  Will it go to bonds that yield 1 or 2% or stocks that yield more? I think stocks. 

 

As to corporate tax rates in most studies I have seen the effective rates range from 25 to 30% averaging around 27%.  So I think the drop will be 10%+.  As to retiring the Navy, I would not put a massive cut back on overseas deployment as out of the range of possibility & a resulting decline in the defense budget. 

 

I think these are some of the reasons Fairfax has become more bullish.  You are correct that valuation is high compared to history since 1980 but the underlying assumption is you are expecting interest rates to be the same to make the comparison valid.  I do not think the 1980s interest rates will return for a long time so I use the ERP to gauge equity valuations versus P/Es which include both interest rate and ERP forecasts.

 

Packer     

 

Trump want to "rebuild" the military, not cut it.

[Spekulatius]

Jeff Gundlach:

 

"Look for Trump to "amp up the deficit" to pay for infrastructure and other programs - producing an inflation rate of 3% and nominal GDP growth of 4-6%. Given that, there's no way the 10-year Treasury yield stays near its current level of 2.15%, and it could rise as high as 6% in the next four or five years."

 

Hard for me to imagine this scenario is anything but super-positive for bank earnings.

 

 

...until credit defaults spike and the commercial and residential RE market goes down the drain. Do you think 5% cap rates will exist with 5% treasury LT rates? The write downs and defaults in RE would be staggering and most banks won't survive them.

 

Do you think the economy could withstand 6% rates?  Do you think the Fed would let that happen? 

 

Federal debt interest expense would be something to see under that scenario!

[Graham Osborn]

Given the reported voting tendencies on the board, I would imagine many of posters on this thread were confident of a Clinton victory 1 week ago.  And many of them were probably equally confident that the market would react negatively to a Trump victory.  These same speculators now have Trump's economic plan and its consequences worked out to 3rd order.  It's always hard for people to admit that they don't have a clue what's going to happen - but doing so is critical to generating good risk-adjusted returns.  I prophecy:

 

1. The market could go up a lot.

2. The market could go down a lot.

3. The market might not do a damn thing.

 

My portfolio and I will be equally happy with any of these scenarios.  If I were long-only, yes, I would probably have a sizable cash cushion - but that would have been true for most of the past 15 years.

 

[Spekulatius]

Given the reported voting tendencies on the board, I would imagine many of posters on this thread were confident of a Clinton victory 1 week ago.  And many of them were probably equally confident that the market would react negatively to a Trump victory.  These same speculators now have Trump's economic plan and its consequences worked out to 3rd order.  It's always hard for people to admit that they don't have a clue what's going to happen - but doing is critical to generating good risk-adjusted returns.  I prophecy:

 

1. The market could go up a lot.

2. The market could go down a lot.

3. The market might not do a damn thing.

 

My portfolio and I would be equally happy with any of these scenarios.

 

Mr Market went from "disaster scenario" to "blue sky" after the Trump victory. I think it is premature to make any predictions, what our President will or can do. I honestly think, he doesn't know himself. I personally expect way more volatile in the future than in the past. Personally, I like volatility and hope to benefit from it.

[rb]

I think you framing of interest rate changes is missing something.  What is important is not the absolute changes in rates but the relative change.  Values will double if rates go from 12% to 6% or 3% to 1.5%.  The other thing about interest rates is they do not mean revert they go up and down over long period of times in waves.  The current cycle began in 1980 so it is 36 years old.  The last two long term cycles were about 80 years in duration.  The Victorian deflation ran from 1820 to 1900 and the Great Reflation from 1900 to 1980.  These are described in The Great Wave.  So we are about half way through this cycle so comparing PEs now to 1980 is comparing apples & oranges as the interest rates environment is completely different.

 

As to increased demand I think that what is missed is where will the wealthy savings go?  Will it go to bonds that yield 1 or 2% or stocks that yield more? I think stocks. 

 

As to corporate tax rates in most studies I have seen the effective rates range from 25 to 30% averaging around 27%.  So I think the drop will be 10%+.  As to retiring the Navy, I would not put a massive cut back on overseas deployment as out of the range of possibility & a resulting decline in the defense budget. 

 

I think these are some of the reasons Fairfax has become more bullish.  You are correct that valuation is high compared to history since 1980 but the underlying assumption is you are expecting interest rates to be the same to make the comparison valid.  I do not think the 1980s interest rates will return for a long time so I use the ERP to gauge equity valuations versus P/Es which include both interest rate and ERP forecasts.

 

Packer     

On effective corporate taxes here's the GAO: http://www.gao.gov/products/GAO-16-363. You can also do a quick back of the envelope check using federal corporate tax receipts (around 350 Bn i think) and corporate profits. It'll show you the same thing that effective federal corporate tax rates are quite low. You can get the number from BEA and CBO.

 

Most of the military spending is on equipment not on people. While you can certainly save some money by pulling back forward deployments, Trump also pledged to rebuild the crumbling military.

 

As others have mentioned. No one (maybe not even himself) has any idea what he'll do. I'm just going by what he actually said and doing numbers. What the numbers say that unless you're willing to blow the deficit sky high he won't be able to do a lot of what he promised so he'll have to only do a part. I'm leaning toward the high earner tax cut and maybe some of the corporate tax cut.

 

When we're talking about demand we're talking about 2 different things. I'm talking about economic aggregate demand and you're talking about demand for assets. I agree that a high earner tax cut will increase demand for assets and boost prices. But without an improvement in fundamentals driven by an increase in aggregate demand that's just asset price inflation aka a bubble - not exactly what I'm looking for when making investment decisions.

 

As I've pointed before my exuberance is tamped down by valuations - those still matter. If the S&P P/E would be half what it is I'd be a lot more exuberant.