Over the weekend, I described the prevailing market narrative as being “full of embedded contingencies.”
While the direction of risk assets will likely hinge on the path of the dollar in September, when assessing where things go from October through the end of the year, traders will be intently focused on quantitative tightening, trade and the U.S. midterms.
On the QT front, do note that the ECB will taper asset purchases to €15 billion/month from September. Meanwhile, the Fed’s balance sheet rundown is proceeding and on Friday, the Bank of Japan announced they will reduce the frequency of purchase operations this month (although they’ll also be upping the purchase sizes across maturities in an effort to assuage concerns).
As far as trade goes, you already know the story there. It’s anyone’s guess what Trump is going to do next, but a further escalation with China in the form of tariffs on $200 billion in additional goods (and retaliatory differentiated duties on $60 billion in U.S. items) seems like a foregone conclusion.
When it comes to the midterms, the risk is that the House flips to Democrats prompting a deluge of investigations that the White House is said not to be prepared to handle. We talked at length about this in “House Flipping: GOP Quietly Ponders ‘Coming Hell’ After November“.
Trump’s mounting legal problems will likely influence voters and if his decidedly ill-advised decision to lambast Jeff Sessions for indicting Republicans is any indication, the President is acutely aware of the possibility that Democrats will gain ground in November.
The base case scenario on Wall Street is generally inline with prediction markets: The House flips to Democrats and Republicans retain control of the Senate.
In a new note out Tuesday, BofAML takes a look at the policy implications of multiple scenarios as well as the likely impact across assets of the different outcomes. While the bank cautions that projections should be “taken with a grain of salt” in an era where surprise after populist surprise have made fools of professional pollsters, their assessment is consistent with the models and pundits. To wit:
The Republicans currently have a 23-seat majority in the House but conditions appear favorable for the Democrats to swing the majority in their favor in the fall. The Democrats start out with a structural advantage with 25 House Republicans sitting in districts that voted for Clinton in 2016 versus 13 House Democrats sitting in districts that voted for Trump. Additionally, Democratic challengers are out-fundraising Republican incumbents. According to Politico’s analysis of the latest fundraising numbers, out of the 59 challengers who outraised their incumbent opponents, 56 are Democrats. Tack on another 38 House Republicans not running for reelection and the math works in favor of the Democratic wave. Models and pundits concur: According to FiveThirtyEight’s base model, the Democrats currently have approximately 70% chance of winning control of the House with an average net gain of 33 seats while the Cook Political Report, a nonpartisan political think tank, currently scores 38 Republican House seats as “toss-ups” or worse compared to only 3 Democratic House seats vulnerable to flip with another 21 Republican seats that are considered “competitive”.
While the bank concedes that the math is “challenging” when it comes to the Senate, they concur that the GOP has the upper hand there.
Rather than work through all of the possible deviations from that base case, it’s easiest to just assume it for the time being when it comes to extrapolating policy and the impact on asset prices. When it comes to policy, BofAML essentially predicts that nothing is going to get done before 2020 if the base case outlined above for the midterms plays out. Here’s some color on that:
In our view, a split Congress means very little legislation will pass in the next two years. Our expectation is based on the fact that the two parties are running on vastly different economic policy platforms. The Democrats’ priorities look to increase government spending and raise the minimum wage while the Republicans will look to cut spending and lower taxes. Accordingly, we see little room for compromise on major fiscal policy issues and do not expect the outcome of the midterm elections to meaningfully alter our outlook.
Here’s a table that breaks down how the bank sees policy evolving (or not evolving) contingent on different outcomes in the House and Senate:
As far as rates and the dollar are concerned, the bank has this to offer in the introduction to a lengthy section that breaks down all manner of possibilities and puts things in historical context (again, I’m cutting straight to the point here, in the interest of brevity):
The rates & FX markets have had mixed reactions to mid-term elections in recent years, but we expect that this year’s mid-terms could be more consequential than most in the recent past. We expect that any scenario in which the Democrats take one or both chambers of Congress will likely lead to a deterioration of risk sentiment given expectations for gridlock and a less favorable regulatory environment which should lead to lower rates, a flatter curve, and a modestly weaker USD (Exhibit 2). In contrast, we think a Republican hold of both chambers would bolster risk sentiment and likely see rates rise, the curve modestly steepen, and USD strengthen.
The good news about gridlock is that, at least in BofAML’s mind, it would be positive for equities. The rationale behind that assessment is that a Republican sweep could open the door to an even more combative trade stance from the Trump administration and while the gains from late-cycle stimulus are already in the books, the potential downside from the trade frictions has yet to be realized.
“Many of the positives expected from the 2016 election outcome have materialized (tax reform, pro-business agenda) and the next policy hurdle under the current administration is trade, which has puts and takes for US equities”, BofAML cautions, adding that “whereas the key positive of tougher trade negotiation is striking better deals for US manufacturers, the risks are manifold, from margin pressure to stagflation”. The bank then lists three key points about globalization and the impact on corporate America:
- Note that half of the margin expansion of the S&P 500 since the 90s can be attributed to globalization (tax and labor/cost arbitrage).
- Note the increasing of import costs and reduction in exports would be an unequivocal negative hit to S&P 500 earnings.
- And note that Corporate America, which has just emerged from the bunkers to begin spending on capex and growth, might crawl back under its shell in the face of trade uncertainty, stymying economic growth.
Trump doesn’t like to mention all of that, because it suggests that his trade war is actually working at cross purposes with the tax cuts, in yet another example of this administration’s policies tripping over one another.
Thus, the best outcome for stocks is actually gridlock or, as the bank puts, it “do nothing, and undo nothing.” I suppose this would amount to the return of the “noisy status quo” (to quote Deutsche Bank’s Aleksandar Kocic).
A simple look at history supports that contention. “Historically stocks have thrived in gridlock: under a Republican president, a split Congress has been the best outcome, yielding 12% average annual returns for the S&P 500”, BofAML notes, referencing the following chart:
The bad news, though, is that history shows the S&P posted its worst returns 10 and 20 days following the midterms when the President’s party loses the House majority:
Of course the real elephant in the room here (pardon the partisan pachyderm pun), is the Mueller probe. After all, there’s no historical precedent for a sitting President getting himself indicted for obstructing justice via tweet.
If you’re wondering what would happen should Trump get impeached, the answer is obviously “who knows”, but if you ask the President, chances are “everybody will be very poor”…
Spoken like a “very stable genius.”