Analysts love to point out when they’re right. They publish long essays highlighting the predictions that happened to come true. 1 1 Close Occasionally they allude to something they got wrong too, in an offhand manner. We’re reluctant to do that, but the recent election gave us an opportunity we couldn’t resist. Two weeks ago, we wrote that we didn’t know how markets would react to the election. We were right: we didn’t know. Unfortunately, it seems that plenty of other folks didn’t either. The general consensus among strategists was that the worst outcome for equities would be a contested election result. The second worst would be a split-Congress with a Democrat president. Well it seems we’ve sort of gotten a somewhat contested election result and, barring a surprising outcome in the Georgia runoffs, a divided Congress. 2 2 Close It’s not clear if this counts as a contested election. There is uncertainty over whether we are uncertain about the result of the election. Yet equity markets rallied last week. It’s as if the markets are either ignoring the election results or ignoring predictions of what they should do.
The election’s effect on markets comes down to a fairly narrow set of issues. While market participants had some mild fears of a constitutional crisis, they were primarily focused on fiscal and regulatory policy. Back in the Clinton years, equity and debt markets welcomed a divided government. Market participants felt that gridlock would lead to fiscal discipline because neither party would be able to enact excessive spending or tax cuts. With government out of the way, the private sector could thrive. Corporate earnings and multiples both rose during that period. These days, markets fear deflation and stagnation so they prefer fiscal stimulus over balanced budgets. Many had felt that if Republicans became the opposition party, they would use the opportunity to embrace their most obstructionist tendencies. Some argued that they would block infrastructure spending and prevent compromise on another COVID aid bill. It’s funny to see that some of the same folks who had embraced the grunge-era fiscal discipline are now worrying about how the economy would fare without government stimulus.
So then why did the markets rally? Perhaps market participants had feared the blue wave more than most analysts did. If Democrats and in particular progressives had won more seats, there might have been pressure on Biden to pick cabinet members who were more friendly to regulation than to markets. Or markets may have rallied because there were some early signs that the gridlock may not turn out to be so bad. Newly reelected Senate majority leader Mitch McConnell said that another COVID stimulus package was possible before year end, although later statements indicate that cooperation may not be as forthcoming. 3 3 Close CNBC: “McConnell says reaching an economic stimulus deal is ‘job one’ when Senate returns,” 11/4/2020.
Whether or not they can work out a spending deal, the divided government will reduce the chances of tax increases, which would have been very likely in a blue wave. Equities tend not to like higher taxes on corporate earnings and capital gains. During the Trump administration the markets tended to balk at trade conflicts then later recover. The Biden administration will probably be less confrontational in its approach to trade, regardless of the composition of the other branches of government. 4 4 Close Congress must ratify any treaty, but the executive does the negotiation.
Markets seem to have a sudden renewed faith that the Fed will help them out. This may explain why both bonds and stocks rallied last week. However, this is difficult to square with the results of the election, if it in fact leads to gridlock. The Fed has been clear that it would prefer not to lower rates from here, so any further stimulus would likely be through asset purchases. In the past crisis (meaning the one earlier this year), the Fed was able to extend its programs across the credit curve by leveraging capital from the fiscal programs. If it is unable to do that because there are no fiscal programs, the asset purchases will not be nearly as effective. Perhaps investors think that the Fed has enough ammunition to offset a mild slowdown, and if there is another crisis, the factions in government will work together like they did back in the spring.
Right now, investors are following the Senate with far more interest than they normally do. The runoffs in Georgia will determine the balance of power – there is still a small possibility for a 50/50 Senate which would be a blue wave lite result with the Vice President giving the Democrats the deciding vote. 5 5 Close For what it’s worth, polls currently favor the Republican candidates. Source: Real Clear Politics. Investors will continue to follow every word from McConnell and moderates like Joe Manchin to see where the compromises might be. But this may turn out not to be a good use of time. Making investment decisions based on politics is like booking an event at the Four Seasons (Landscaping). The trades seem like they’re going somewhere glamorous, but they often end up in a different place than you had planned. 6 6 Close I’ve had plenty of trades that seemed like they would end up at the nicest hotel in town, but instead ended up across the street from a crematorium.
In the coming weeks and months, politics will be likely become less important, and the direction of the economy will reassert itself as the primary driver in macro. We already are starting to see that with the reaction to the vaccine news on Monday. The path of the health crisis and the government response will have a big effect on the direction of the economy. Markets are now betting on a continuation of the recovery. The threat to that would be a shutdown or a change in consumer behavior as a result of the pandemic. The data will matter more and more during the winter. You can stop refreshing your election results feed twice a minute and start following some economic news. 7 7 Close I checked my election feed in the middle of typing that sentence.
What We Are Watching
COVID-19 Cases and Government Responses
The substantial increase in COVID cases, hospitalizations and deaths in the past several weeks in Europe and the U.S. may be starting to dampen the market’s optimistic response to the U.S. election and positive vaccine developments. While a number of European countries have implemented strong containment measures via lockdowns and curfews, the U.S. has for the most part taken a lighter approach thus far, emphasizing mask-wearing and social distancing in most places. In some states, the approach is shifting toward more strict limitations on social gathering, indoor dining, and other activities. As the U.S. breaks records in daily cases and hospitalizations in a broad-based manner across different regions of the country, market concerns about large-scale lockdown risks appear to be rising. Public health developments are likely to remain a key driver of the economic outlook and market sentiment in the weeks and months ahead.
China October Monthly Activity Data (Monday)
The Chinese economy has bounced back in recent months as domestic COVID cases have been contained and lockdown measures have eased. However, the recovery has been uneven. Industrial production has been quite strong, returning to positive YoY growth in April and accelerating to high single digit growth in August and September. In contrast, retail sales data has been sluggish, showing YoY declines through July before edging into positive territory in August and September. This divergence runs counter to Chinese policymakers’ longstanding goal of boosting the share of consumption in GDP and has contributed to a widening Chinese trade surplus. News reports suggest that October may have been a strong month for Chinese consumer spending, boosted by activity during the “golden week” holiday at the start of the month. 8 8 Close South China Morning Post: “China ‘golden week’ holiday spending rebounds from coronavirus with daily spending up 4.9 per cent on year,” 10/9/2020. Domestic equities could react positively if data released this week confirms continued improvement in Chinese consumption.
U.S. Retail Sales (Tuesday)
U.S. retail sales grew at a substantially higher-than-expected rate in September, continuing with the broad theme of economic recovery since the initial lockdowns were lifted. Strong performance in the apparel and department stores categories, presumably associated with back-to-school spending, supported sales last month. The resilience of retail sales data suggests that consumers have shifted their spending towards goods even as reduced mobility and health concerns have constrained services demand. Next week’s data will provide an update on the behavior of consumers in response to rapidly rising COVID cases in various states in October. While there were not widespread mandated lockdowns in the U.S., the noticeable increase in cases may have resulted in behavioral changes in consumers. Should data show a slowdown in retail sales, it could raise concerns that the consumer is losing momentum as public health conditions deteriorate.