US Tax Reform

The House tax reform bill was passed last week but now faces a competing Senate tax plan which faces a much smaller Republican majority. The Senate bill will require unanimous support amongst the Republicans if it is to have a chance of passing. A lot rests on tax reform. The stock market has priced in the highly accretive impact of corporate tax cuts and the expected boost to growth has been priced in the treasury and FX markets as well. If the tax reform is delayed or considerably watered down, expect stronger treasuries, weaker equities and a weaker USD at least in the near term. Balancing this was data showing that both inflation and industrial production perked up in October in a sign of the economy’s underlying strength.


Bank stocks had priced in higher interest rates and faster inflation, perhaps a little ahead of time, in the past year. The uncertainty over tax reform in the US, and the market’s scepticism that the Fed will deliver on all 3 rate hikes in 2018 has moderated optimism for the sector. In Europe, miscommunication by the ECB regarding treatment of NPLs also hit bank stocks. This is a buying opportunity.

  1. The market is pricing in a 13.6% chance of 3 rate hikes. Looking at the strong economic data, especially in the labour market, the Fed is likely to deliver all 3. US banks earnings correlate to the 2 year rate, not the 30 year rate. The 2 year rate will be more sensitive to Fed Funds rate than to inflation.
  2. Inflation is creeping up in the US. Latest CPI numbers show some firmness in inflation which could surprise on the upside later next year.
  3. European banks are well capitalized. They are sufficiently capitalized that they will now be acting to lower cost of funding by refinancing legacy capital into debt. This will improve interest margins even without the ECB tapering or raising rates, which we think is still far off. They are also sufficiently capitalized to start growing loan books. Expanding margins and revenues are positive for earnings and European banks are still cheap (the sector trades at 0.82 book).

Fixed Income Update

The continuing re-leveraging of the US corporate sector leads us to favour household balance sheets over corporate ones. The natural trade is to be overweight mortgage bonds and underweight corporate bonds. The dwindling issuance of non-agency RMBS and the difficulty of finding bonds, whether directly or through a fund, has led us to explore the new agency credit risk transfer market. These are also not easily accessible directly or by ETFs so specialized funds have to be sought. The sector is attractive as credit quality is strong, however, as a result, yields are low. The area we are most interested in are the mezzanine bonds of these securitizations.