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Trump's war on private debt to reshape markets: James Saft

[January 10, 2017] By James Saft

(Reuters) - (The opinions expressed here are those of the author, a columnist for Reuters.) Donald Trump's prospective attacks on private debt contrast strongly with his apparent comfort with rising public indebtedness. If carried out, both will have a massive impact on financial and asset markets.

Plans advanced or being considered by the President-elect and Republican leadership will make mortgage and corporate debt far less appealing to borrowers, potentially hitting house and share prices. At the same time, likely tax cuts and spending plans will inflate the public debt and boost economic growth, pushing yields on Treasuries higher.

Disadvantaging private debt while increasing public borrowing will have a mutually self-reinforcing effect, as rising interest rates make borrowing even less attractive for households and firms and increase the downward pressure on asset prices.

Like everything Trump proposes or considers, this may never happen, and financial markets certainly are not trading as if it will.

Under Republican House tax plans from last summer endorsed by Speaker Paul Ryan, the standard income tax deduction for married couples will almost double to $24,000. That's high enough to make taking the standard deduction more attractive than deducting mortgage interest for more than eight in 10 tax filers, according to the Tax Policy Center. For a vast swath of Americans, using debt to buy housing will suddenly make a lot less sense.

Trump's plans for corporate tax reform are similarly hostile to debt, no small irony for a man whose businesses have been liberal users of leverage, and, on occasion, defaulters on obligations.

Trump's pre-election plans called for eliminating the tax deductibility of interest expense for corporations as part of a framework designed to encourage domestic capital expenditure while cutting corporate tax rates. A similar plan has been put forward by Ryan.

Although analysts have paid more attention to Trump's proposals for a tax holiday for foreign earnings, and to plans for what amounts to a border tax that would penalize imports and subsidize exports, the anti-debt provisions would represent an earthquake in both the corporate finance and financial markets.

Total corporate debt, not including borrowings by finance firms, has grown by nearly 70 percent since before the financial crisis as companies, lured by low rates and encouraged by tax treatment, chose to borrow rather than sell equity to finance investment and fund dividends and share buybacks.

DEBT WHERE IS THY STING?

All of the tax cuts mooted by Trump and Republican leaders, along with planned infrastructure spending, are going to cost money. A pre-election analysis by the Committee for A Responsible Federal Budget found Trump's plans would increase the ratio of public debt to GDP to 105 percent by 2026, compared with its current path of 86 percent.

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U.S. President-elect Donald Trump speaks at his election night rally in Manhattan, New York, U.S., November 9, 2016. REUTERS/Carlo Allegri

All of this spending, tax cuts and public borrowing will have a positive near-term impact on growth but will send interest rates higher, as we've seen with the Federal Reserve turning decidedly more hawkish. Ten-year Treasury yields, which form a baseline for much private borrowing, are already up by more than a third, to 2.37 percent, since shortly before the election.

It is important to stress that it is very uncertain what Trump and his Republican colleagues will actually attempt and be able to do. There will be fierce lobbying by the housing and mortgage industries to protect the mortgage deduction, for one thing. Plans to do away with corporate debt subsidies will also face opposition and may well not survive the inevitable negotiations and horse-trading as a tax reform plan moves toward reality.

If, however, even a proportion of the plans described above make it into law, we are going to see some big impacts on financial markets.

House prices will take a hit as the effect of the mortgage deduction subsidy falls away. Because the very wealthy may still itemize their deductions, the brunt of the impact will be felt in middle class housing and below, rather than at the top end.

But homebuilding and other real estate-related stocks will feel the chill.

The effect of eliminating corporate interest deductibility might be even more profound. While companies pay an effective tax rate of 30.8 percent on equity-financed investments today, according to the Council on Foreign Relations, the tax cut of debt funding is actually -7.4 percent. Naturally, companies now favor equity over debt. Under Trump's plans, both equity and debt-financed investments will incur a tax rate of about 10 percent.

Corporate debt issuance will sink like a stone. So will share buybacks, though they may get a short-term bump from money brought back under any U.S. tax holiday. The math of borrowing in bond markets to buy back shares will get a lot less pretty. That could hurt share prices.

Corporate debt as an asset may get a bump. There will be less of it around and company finances may ultimately become more robust as companies pay down debt and issue equity.

In short, if Trump indeed does what he's indicated, the long-running romance between the U.S. private sector and debt will turn cold.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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