In just under a week’s time, its US election day. For economies that have been reeling from the COVID crisis, either continuity or a clarity of outcome is more important than who actually wins. Regardless of the victor, fiscal policy will have a big part to play in this economic future. That’s the Big Conversation.
Firstly, I’m not going to make any predictions about the election itself or the suitability of each candidate. I’m more interested in what happens to the markets. What I am going to look at is the potential outcomes under various scenarios, without saying which of them would be the most likely. As I mentioned at the start, this election takes place under extremely unusual circumstances, with the COVID crisis still ravaging the world’s economies, forcing policy makers to turn to fiscal support on a scale that many western economies have not seen in years. That’s not to say, however, that we haven’t had unusual backdrops in other elections over the last 20 years. In 2000, the dot com crisis was starting to unfold, with the Nasdaq having peaked earlier that year on its way to a decline of over 80% that would last for nearly three years.
The 2008 election took place during the depths of the great financial crisis which had been rumbling on for a couple of years by that stage and then SPX accelerated in September of 2008 with the Lehman bankruptcy and equity markets reaching their lowest levels for the year in late November. The equity market did bounce into and then decline after the election, but the tone was set by other factors. But the key difference today is that the policy response to most of the crises over the last twenty years was generally a monetary response –initially with interest rates being cut and then after the GFC, policy makers also turned to extensive bouts of Quantitative Easing or QE, in which assets were also purchased as well as interest rates being cut. Whilst this QE may have helped stabilize asset prices, with equities in the US and long bonds in Germany performing particularly well, it has done little to deliver long term economic growth and many consider that these policies have widened the income and wealth gaps, particularly in places such as the US and UK. In fact, many would also argue that the last two decades of monetary policy have weakened economies to the point where they were unable to survive the COVID shock without the direct intervention of fiscal expenditure. In many cases, these fiscal expenditures will be widening out the budget deficits and pushing up the debt to GDP ratios.
The US is going into this election as one of the countries which has turned to significant fiscal support. Both Trump and Biden are expected to increase that support if they win the election, but the speed and size of that support could be crucial and that will depend on the result. For this election I am using three basic outcomes (although there are obviously far many more permutations. The first is where we get a relatively known quantity of government, so for instance Trump wins the race for the White House and the Republicans hold the Senate, maintaining the current status quo OR where Biden becomes president and the Democrats win the Senate. A true clean sweep is possible, where one party takes the White House, Senate and the House and therefore controls Congress. The Democrat’s hold on the House suggest that they are unlikely to be dislodged at this election – though as we’ve seen the world over in recent years “never say never” at a major election. The second outcome is where we get a split result. Trump, for instance, retains the presidency but the Democrats take the Senate, OR Biden becomes President and the Republicans hold the Senate. The third outcome should be a temporary one – or at least most investors will hope it is – where the election is contested, with no clear immediate winner. In 2000, the last time there was a contested election, it took over a month for the final result to be declared. When thinking about these outcomes, people will primarily be concerned with the equity market, the dollar, bonds and gold, but in most cases, the post-election trends may have already been set by the macro-economic forces that were in play over the preceding months. In fact, something this year may have to give. Only once in the last 100 years has an incumbent President experienced a recession in the two years prior to an election and been re-elected, according to Strategas Research Partners. If, however, the equity market has been up in the 3 months prior to the election, they note that the incumbent was returned to office on 87% of those occasions (and 100% since 1984). As of Wednesday morning, the S&P500 is just up over the last three months, so it’s getting close, but as it currently stands, one of these two indicators might have to fail this time around.
Despite the trend for the US equity market to perform well during election years (there’s only been four down years since 1928), the period immediately into and out of an election is affected by the level of uncertainty. When the outcome is uncertain, the S&P usually moves sideways before the big day, but once the election result is known, the equity market usually rallies as investors again start to allocate capital. Three of the last four cycles saw the equity market rally in the following three months after the election. Only in the case of the 2008 election did the market decline and that was in the midst of the GFC. In 2000, during the last contested election, which is considered a possibility again today, the S&P did lose ground whilst Florida re-counted and then Gore challenged the result – but was the equity weakness to do with the election or to do with the unraveling of the dot-com bubble? As we can see in this chart, the equity market actually rallied in the final few days of this period of uncertainty. This year of course, we have had the exogenous shock of the COVID crisis and the swift and emphatic response from both the fiscal and monetary authorities, which have distorted price action through most of this year. Fiscal policy will continue to play a lead role regardless of who wins. But if this election is contested for a prolonged period of time and given that the S&P is still fairly close to its all-time high, despite this week’s weakness, it would come as no surprise if the S&P declined, probably more than the 4% decline in 2000. This is a market that currently relies on fiscal and monetary support, although the central banks will no doubt be on standby if market weakness became too excessive. A contested election should hopefully be resolved and that would take us into the other two broad scenarios.
Now I am bunching together what initially appear to be two wildly different scenarios, such as a clean sweep for Biden and the Democrats……… OR…….. Trump and the Republicans holding both the presidency and the senate. And that’s because both these outcomes would reduce the level of uncertainty – one is an emphatic win with clear implications and the other maintains the status quo. The lower the level of uncertainty, the greater is the likelihood that investors will quickly return to the market. Overall equities should move higher, though the focus would be on how well the US performs versus other regions. Under both scenarios, we should expect extensive fiscal packages supported by monetary policy. If the Democrats were to win the Presidency plus the Senate, whilst holding onto the House, then expectations would be for a larger and swifter support package than if the Republicans simply maintain the status quo. Ironically, a true clean sweep by either party would actually have the most similar initial outcomes because both would have equal power to grapple with the exogenous impact of COVID. Obviously there are concerns that Biden would implement higher taxes – but again here the impact of the COVID crisis today should delay the implementation of those policies.
What about bond yields? Could they rise if we get a clean sweep by one party or the other that leads to a swift fiscal response? There has already been a squeeze higher in longer dated yields, but central banks will be very wary about letting these get out of hand. Yield curve control has been discussed by the Fed. If yields started to move dramatically higher, it would destabilize risk assets - and central bankers have been trying to damp down the worst excesses of volatility. Therefore, yields could rise, but it would likely be met by a central bank policy response. Yields would underperform inflation in this environment, because actual yields would be suppressed even if inflation picked up. This would push real yields lower. Lower real yields have generally been great for precious metals such as gold. If this also came with a reflationary impulse, then industrial metals would perform well, making silver look very attractive. For the US dollar, the expectation of more fiscal and monetary support, including higher budget deficits, are expected to weaken the currency but will the US be operating in isolation? Currencies are a relative game, so whilst the policy response under both regimes could be extreme by historical standards, they may not be extreme when compared to other countries.
The dollar should be weaker if there is a clean sweep, because a unified government would be able to act decisively. The underlying weakness of the economy and ongoing issues around the COVID pandemic mean that both parties would be following a similar route. If the USD drops, then we could expect to see foreign equities outperform the US. A weaker USD has generally been good for the relative performance of emerging market equities as we can see on this chart of the DXY next the ratio of the S&P versus MSCI Emerging Markets . The ratio of the SPYDER ETF versus EEM looks like it may be forming a head and shoulders top and the recent outperformance of EEM could accelerate if the dollar drops. It is less clear cut, however, for European equities. If US policies are truly reflationary, then European equities such as the Eurostoxx50 index will perform well because they are a play on global growth. If however, the policies are reflationary primarily for the US, then Europe could struggle, as we have seen over the last few months, where the Eurostoxx50 has underperformed the S&P500 with the recent bout of euro strength. Therefore, I would prefer to play EM equities over European equities if the dollar starts to weaken. The third scenario outlined was the one in which either Trump wins the presidency and the Democrats win the senate OR Biden wins the presidency and the Republicans win the senate. In both these cases, it would be a far more attritional and divided outcome. This outcome would increase uncertainty and therefore the potential upside in the equity market would be muted for an extended period of time. Long end bond yields should fall. Net non-commercial – also known as speculative positions – have become increasingly short in the 30-year space in an anticipation of a large fiscal impulse. If there is political disunity, bonds could rally and yields could fall. Although inflation expectations may be reduced, the decline in bond yields should keep long end real yields close to their lows. That would be another scenario in which precious metals would thrive, although the emphasis would be more on gold than silver, because the reflationary impulse which helps industrial metals would be lost – one of the reasons that silver underperformed during March’s deflationary hit. If there was a gridlock on the policy response, then it would eventually have a negative impact on the economy. This would lead to a backloaded fiscal stimulus, again because of the underlying fragility of the economy. Therefore, whilst a unified government would see a swift stimulus, a gridlock could eventually lead to a bigger stimulus because of inaction. A gridlock would be less emphatic for the US dollar. Uncertainty may weigh on the currency, but equally the lack of immediate fiscal fire power may allow other regions such as Japan and Europe to steal a march on the US in implementing additional support measures. So in summary, if either there’s a clean sweep, we should expect a bigger fiscal response. If the White House and Senate spoils are shared, the fiscal response could be delayed, and this should see long end yields fall.
Maintaining the current status quo, whilst still divided, would maintain continuity and familiarity.
If it’s a contested election with no clear winner for the foreseeable future, then US assets could come under pressure as they did during some of the debt ceiling impasses of the last decade, where the US equity market actually underperformed other global benchmarks. But if things do start to get hairy the US Federal Reserve will still be there to try and calm markets by capping volatility in all the asset classes. In the medium term however, the Covid crisis will drive even a divided government to converge on similar fiscal policies. The 2020 election will still be overshadowed the impact of COVID. As discussed in the first section, it has already seen a generational shift toward fiscal policy in which the central banks will play more of a supporting role. In fact, many think this will lead to more extreme measures of fiscal stimulus such as Modern Monetary Theory and the introduction of a Universal Basic Income if the initial rounds of government expenditure fail to ignite real economic growth. Even in the short term we can see how the ongoing impact of the COVID crisis continues to weigh upon the market.
This week in Europe, the German DAX had lost 7% by Wednesday morning, led by a near 24% fall in the in the tech company SAP after it cut its sales forecast due to the effects of the pandemic, again highlighting the gulf between European and US tech names. SAP is one of the largest components of the DAX and by far the largest component of the Pan European tech sector.The European Service sector PMIs have been dipping back into contraction territory over the last couple of months, with the eurozone October reading coming below expectations at 46.2, having been as high as 55 in July. The US equivalent, on the other hand, beat expectations at 56. Whilst one of the focuses for this election is whether Trump and the Republicans or Biden and the Democrats will be the most active on the fiscal front, it may well be Europe that needs to return with another round of monetary and fiscal support. The next ECB meeting is Thursday 29th October, though most observers expect that the they will be on hold until after the US election to gauge the nature of the US administration. The last ECB meeting of 2020 will be on December 10th.
So far, monetary policy has had very little effect on the real economy – the main impact has been on asset prices. Eurozone inflation remains very weak, with the German HICP numbers again falling into negative territory. Economies have not recovered. So far, fiscal policy has provided support, not stimulus. It has helped economies rebound, but not recover to their former levels.
Until fiscal and monetary stimulus create more growth and more demand than has been lost through the pandemic period, then the short-term outlook remains disinflationary. Whilst economies maybe on an upward trajectory, they are starting off a very low base with multiple headwinds still in place. Manufacturing economies which appear to have returned to full growth may find there’s not the end demand for their goods. This is why we should expect policy makers around the world to continue with their efforts to SUPPORT A SHORT TERM REBOUND at the expense of efficiency. Long term growth prospects will therefore remain subdued so that, even once the economy has seemingly fully recovered, it will be left structurally weaker again, just like it was after the dot com bubble and then the GFC.
Turning back to the election, what would constitute a shock for the market? I don’t think anything will surprise this market as readily as the election of Trump in 2016. The price action that year was far more dramatic than could be attributable to other exogenous forces. On the day after the election itself, the first move in many asset prices was a knee jerk move lower. But, once the realization kicked in that Trump and the Republicans had won a clean sweep, the markets quickly reversed. But what was even more emphatic was the outperformance of specific sectors. The mid cap Russell 2000 index outperformed the S&P500, whilst US equities in general outperformed emerging markets, on the expectation that Trump would now have the clout to push through policies that favoured US industry, especially domestic manufacturers. Tax cuts were also being priced in. The US dollar also rallied, with the DXY reaching its highest level of this cycle so far. This reflected the positive side of the US dollar smile, where the dollar is strong during times of strong US outperformance relative to the rest of the world. The other side of the smile is where the dollar is strong during periods of economic stress, like at the end of 2015 when the global manufacturing recession was taking place. The dollar is at its weakest when there is coordinated global growth (or reflation) and the higher beta currencies of EM or commodity countries tend to outperform. But what should be noted is that the Trump bump of the time only lasted a couple of months before the underlying global trends reasserted themselves. In 2017, we saw a continuation of the coordinated growth that kicked off in early 2016 when China again injected vast amounts of credit into the system. The dollar started to sag as global growth picked up. US equities performed well, but underperformed the broad EM equity space.
So can this election create as much as a shock as 2016? It might be a surprise if one Party achieves the clean sweep of the Presidency and Congress……but that still wouldn’t constitute a shock. The real shock, the pandemic, is still working its way through the global economy and until this has been resolved, the policies of both sides are likely to be more convergent than the personalities who are vying for power.
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