The unusual current political environment makes typical market patterns around midterm elections less reliable than might otherwise be the case.
That’s from a Goldman note out Friday evening, and the deadpan tone is amusing.
To say the current political environment in the U.S. is “unusual” is an understatement of epic proportions. Donald Trump is now explicitly pitching the midterms as an election about “Kavanaugh, the caravan and common sense.” Here, look:
Just so we’re clear, the midterm elections, according to Trump, are about a Supreme Court Justice whose nomination was marred by allegations of sexual assault, a caravan of Honduran migrants stuck on a bridge connecting Tecun Uman, Guatemala, and Tapachula, Mexico, and “common sense”, something the American electorate simply does not possess.
In reality, the midterm elections are about Donald Trump. Period. This is a referendum of two years worth of “covfefe”, where that means combative foreign policy (even towards traditional American allies), protectionist trade policies gone wild and a domestic political environment that is so divisive, there is no adjective strong enough to describe the scope of the polarization.
That said, Goldman writes on Friday that with exception of the most recent tumult, volatility in U.S. equities has not followed the historical pattern in the lead up to elections.
“One clear historical pattern around midterm elections is a rise in both economic policy uncertainty and equity volatility in the months before Election Day”, the bank says, before noting that “until this month’s drawdown, both realized and implied equity volatility had been exceptionally low during recent months.” Here’s some perspective using 30-day vol.
So yeah, there was a flareup recently, but Q3 was tranquil. In fact, there wasn’t a single session that saw the S&P move 1% or more in either direction on a closing basis.
What gives? Well, for Goldman, it could be that markets are simply numb to the political noise.
“Policy uncertainty has been elevated relative to history, but not markedly more than during the last 2 years [and] this may suggest that markets have become inured to above-average political uncertainty and help explain the lack of pre-election volatility”, they write.
While this is a positive development if you think it’s kept a lid on pre-election volatility in the face of ongoing political turmoil (both domestically and abroad), it could also mean that any post-midterm rally is muted.
“To the extent that the typical 8% S&P 500 rally during 4Q of midterm election years – twice the median return of 4% in other years – is driven by declining uncertainty, that pattern may be less likely to repeat this year”, Goldman cautions.
The assumption continues to be that Democrats will retake control of the House with Republicans retaining the Senate. Analysts have variously suggested the ensuing gridlock might actually be a positive for U.S. equities as a divided government might stymie Trump’s attempts to escalate the trade war, while the policies that have positively impacted market sentiment cannot easily be reversed.
Goldman takes a closer look at what the market is pricing in terms of government spending and infrastructure and I wanted to highlight some quick excerpts and visuals on that, as it’s something that could be of interest.
“The performance of Aerospace and Defense stocks suggests the market does not expect a major tightening of fiscal policy [as] the average A&D stock has returned 8% YTD, outperforming the S&P 500 by 300 bp and the broad Industrials sector by 1,000 bp”, Goldman observes (see left pane in the visual below).
As far as expectations for the long-rumored infrastructure spending binge, they aren’t particularly optimistic. The bank admits that lawmakers from both sides of the aisle generally support infrastructure spending, but according to the bank’s economists, a major deal on that front is unlikely. To wit:
We assign just a 25% likelihood that infrastructure spending legislation is enacted if Republicans maintain control of Congress given the likely difficulties surrounding financing. If Democrats take control of one or both chambers, our economists believe a major spending compromise is even less likely.
As far as markets go, it would appear that contrary to what investors will tell you if asked, nobody really believes the infrastructure story. Because if you look at the right pane below, you can see that while Goldman’s basket of stocks that would benefit from infrastructure spending has outperformed lately, it’s still a country mile away from the post-election euphoria.