A market legend is worried… and a jaw-dropping record in corporate debt

From Justin Brill, Editor, Stansberry Digest:

U.S. stocks jumped to new record highs again yesterday…

The rally followed a statement from President Trump, who is planning to announce his administration’s new tax plan within weeks…

Lowering the overall tax burden on American business is big league… that’s coming along very well. We’re way ahead of schedule, I believe. And we’re going to announce something I would say over the next two or three weeks that will be phenomenal in terms of tax.

Trump offered no additional details, but we weren’t surprised to see the market move higher…

As our colleague Scott Garliss noted in the Stansberry Newswire just moments after the news broke, tax reform is a key part of Trump’s “big three” agenda (along with regulatory reform and infrastructure investment) that many investors have cheered.

[Crux note: Stansberry Newswire is our brand-new, real-time market news and insight service, currently available exclusively to Stansberry Portfolio Solutions members. If you’re a Portfolio Solutions member and you haven’t had a chance to see it, be sure to check it out right here.]

In related news, Trump also recently promised to “scale back” Congress’ Dodd-Frank Act…

Trump signed an executive order last Friday laying out a framework to undo many of the law’s financial regulations put in place following the 2008 crisis. As the Wall Street Journal reported at the time…

President Donald Trump ushered in a friendlier era for Wall Street’s relationship with Washington, calling for an end to eight years of rising regulations and publicly embracing some of the industry’s top leaders…

The White House said its goal isn’t to let Wall Street run wild, but to cull back specific rules it believes are impeding economic growth without meaningfully making the financial system or consumers safer.

“We want to do it in a smart, regulated way,” Gary Cohn, director of the White House National Economic Council, said in an interview.

While this would be bullish for the financial sector in general, it could be great news for the big banks in particular…

According to analysts, these moves could allow the largest firms to return up to $100 billion in capital to shareholders through increased dividends and share buybacks.

Analysts from investment bank RBC Capital Markets note the top six U.S. banks hold nearly $102 billion in “excess capital” that could be freed up if regulations are loosened. Analysts at investment bank Morgan Stanley say that figure increases to more than $120 billion when the next 12 largest banks are included.

Count legendary activist investor Dan Loeb among those who expect banks and financials to do incredibly well under Trump…

As longtime readers may recall, Loeb’s Third Point hedge fund returned nearly 20% a year over its first 20 years, making him one of the most successful investors of all time.

According to his latest letter to investors published this month, he first turned bullish on banks and other “reflationary” investments following November’s election.

Specifically, he said he increased his fund’s total financial exposure from less than 5% on November 8 to nearly 12% within a month following the election. But he also noted that even those figures “understate the magnitude” of the shift. From his letter (courtesy of financial-news network CNBC)…

We reallocated half our initial holdings from high multiple, [free cash flow] businesses in Payments, Ratings, and P&C (which traditionally outperform during periods of deflation), to more traditional reflationary exposures in Banks, Brokers, and, geographically, in Japan.

He also noted that he has continued to add to these positions this year…

Our conviction has only increased since we first initiated these investments; we have added exposure to each of the names in 2017.

But not everyone agrees…

Some other notable investors are getting concerned Trump is creating political uncertainty that could undermine the benefits of his pro-growth reforms.

Regular Digest readers know Ray Dalio – the brilliant founder of Bridgewater Associates, the world’s largest hedge fund – was incredibly bullish following Trump’s victory last year. But he now appears to be second-guessing that stance. As Bloomberg reported late last month…

Dalio is now saying he’s more concerned that the damaging effects of Trump’s populist policies may overwhelm the benefits of his pro-business agenda.

“We are now in a period of time when how this balance tilts will be more important to the economy, markets, and our well-beings than normally dominant drivers such as central bank policies,” Dalio and co-Chief Investment Officer Bob Prince said in Bridgewater Associates’ “Daily Observations” note to clients.

Dalio is souring on the new president after he banned visitors from seven mostly Muslim countries, igniting protests nationwide, and proposed a border tax on Mexican goods. Earlier this month, Dalio said it remained to be seen whether Trump is aggressive and thoughtful, or aggressive and reckless. Dalio and Prince said so far they haven’t seen much thoughtfulness in Trump’s policy moves.

Value-investing legend Seth Klarman would appear to agree…

If you’re not familiar, Klarman founded hedge-fund Baupost Group in 1982. He has earned nearly 20% annualized returns since the fund’s inception, despite often holding large amounts of cash. His classic book on value investing – titled Margin of Safety – is so sought-after, even used copies often sell for more than $1,000.

In short, he’s likely the greatest and most respected investor most folks have never heard of.

In his latest letter to investors, Klarman echoed many of Dalio’s concerns (courtesy of the New York Times)…

Exuberant investors have focused on the potential benefits of stimulative tax cuts, while mostly ignoring the risks from America-first protectionism and the erection of new trade barriers…

President Trump may be able to temporarily hold off the sweep of automation and globalization by cajoling companies to keep jobs at home, but bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces.

While they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off.

Klarman is also worried that Trump’s pro-growth policies may backfire. He said they “could prove quite inflationary, which would likely shock investors,” without delivering sustained long-term growth. He also warned they could drive government deficits significantly higher. More from the letter…

The large 2001 Bush tax cuts, for example, fueled income inequality while triggering huge federal budget deficits. Rising interest rates alone would balloon the federal deficit, because interest payments on the massive outstanding government debt would skyrocket from today’s artificially low levels.

While the Times notes Klarman is still “hoping for the best,” he believes investors should be prepared for much more volatility at the very least…

The big picture for investors is this: Trump is high volatility, and investors generally abhor volatility and shun uncertainty. Not only is Trump shockingly unpredictable, he’s apparently deliberately so; he says it’s part of his plan…

If things go wrong, we could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst.

Even if Trump is successful, regular readers know we remained concerned about looming problems in the credit markets…

As Porter and his team have explained, companies across virtually every sector of the economy have taken advantage of super-low interest rates to issue record amounts of debt over the past several years.

Many of these companies have virtually no hope to pay these debts back even if the economy flourishes. In fact, an economic boom would likely hasten their demise… because they won’t be able to handle the rising interest rates that come with it.

We’ve also discussed why it could be virtually impossible for these companies to refinance these debts at reasonable rates…

Interest rates are already likely to move much higher over the next few years… And a huge wave of maturing Treasury debt could push corporate borrowing costs even higher. But a new report from ratings agency Moody’s shows just how massive this problem could be…

According to Moody’s, more than $1 trillion worth of junk-rated corporate debt is due to mature over the next five years. This is the highest amount ever recorded over a five-year period… including a single-year record of $402 billion due to mature in 2021.

In other words, a record amount of “junk” will need to be refinanced at exactly the same time this massive wave of Treasury debt will be hitting the market. This will not end well.

Like us, Moody’s warned that many of these companies could be in big trouble even if the broad market holds up. As the Journal reported yesterday…

Even without a major market downturn, companies could also be burdened in the coming years as interest rates rise and they are forced to replace low-coupon debt with higher yielding bonds and loans, said Tiina Siilaberg, vice president and senior analyst at Moody’s.

Higher interest costs erode “cash flow generating ability and at the end of the day also affects their ability to service their debt,” she said.

Regards,

Justin Brill

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