Obviously, all eyes will be on the U.S. midterm elections in the week ahead.
Everyone’s baseline assumption is that the House flips to Democrats and the Senate stays with Republicans.
The main event
The broad strokes implications are clear. If the baseline scenario plays out as expected, there’s potential scope for compromise on infrastructure spending and, with the caveat that nobody knows who would pay for it, some kind of tax relief for middle income Americans. Do note that neither of those two outcomes (i.e., a sweeping infrastructure proposal or a middle class tax cut) seem “likely” because, again, the U.S. is running the largest deficit since 2012, which means funding for more stimulus is anything but “secured” (to quote Elon).
If Republicans were to retain both the House and the Senate, then you can probably expect a push for Tax Cuts “2.0” and also another run at “repeal and replace” on the ACA.
As far as trade goes, if the House flips to Democrats, it seems likely that the White House will have to confine its aggression to China or risk significant political pushback. If Republicans retain both chambers, it’s possible Trump could press ahead with a combative approach on trade beyond the Chinese, largely unhindered.
Obviously, Democrats will try to bombard the administration with investigations if they retake the House. If they (Democrats) somehow manage to take both the House and Senate, it’s going to be hell on Earth for Trump, although barring significant support from disaffected Republicans or some kind of unprecedented move from Mueller, impeachment appears far-fetched.
As far as what history says about S&P performance under different scenarios, here are a couple of simple graphics from BofAML:
Underscoring the chart in the left pane is Credit Suisse. “It is important not to overreact to an election result [as] there is no clear relationship between past midterm election outcomes and subsequent equity market performance” the bank writes, reminding you that “despite some risks, the likely result of this election is legislative stalemate, a situation that has coincided with good market conditions in the past.”
As far as the dollar is concerned, Barclays’ FX team has gamed out the likely trajectory for the greenback under various outcomes for the midterms. Here’s the gist of it:
We expect the USD to be range-bound against G10 but continue to strengthen against EM under the baseline scenario of a Blue wave. Additional fiscal stimulus is unlikely to come under a divided Congress (we assign a small probability for bipartisan support to a modest infrastructure plan), but the US economy should continue to outperform the rest of the world as the boost from the current fiscal expansion remains. As the Fed continues to account for the demand fiscal shock, markets are likely to raise the probability of the terminal fed funds rate rising above the neutral rate of 2.5-3.0%. Our current forecast set factors in this divergence in US monetary policy, keeping the USD at elevated levels but relatively range-bound vs. G10, and sustained competition for capital flows, keeping the USD strong against EM. We do not expect any change to the restrictive trade policy under this outcome. The Red Wall scenario could affect our views, given its potential implications for a more meaningful fiscal policy boost and broader US trade protectionism. Under a GOP victory, we expect the USD strength to be more pronounced against G10, and especially so against EM.
The dollar is of course sitting near the highs of the year, after running up sharply during the latter part of the October equity meltdown. Here’s the BBDXY:
Folks started adding to the net dollar long again in the week through October 30 and as Goldman notes, “most of the USD net buying occurred against the Mexican Peso as traders (primarily asset managers) reduced MXN net longs, likely driven in part by President Elect Lopez-Obrador’s decision to cancel the construction of a new airport in Mexico City.”
Meanwhile, specs pared their 10Y short again in the week through last Tuesday. Here’s the updated chart on that:
See you in December
We’ll get the Fed this week, and that’s clearly expected to be a “see you in December” type of deal, with no nod given to recent market turmoil. “We do not expect the statement to address the recent volatility in financial markets as most Fed officials believe that overall financial conditions remain broadly supportive of growth”, BofAML says.
Indeed, it’s entirely likely that the Fed views the drawdown in equities as useful to the extent it helps tighten financial conditions, discourages risk taking and acts as an indirect supply of convexity to the long end of the curve, effectively mitigating the risk of a disorderly unwind of the bond trade.
“While the Fed has often been sensitive to substantial tightening in financial conditions, we think additional emphasis on financial conditions in the short statement would send too dovish a policy signal, especially because growth is currently still very strong”, Goldman said last week.
“In the policy statement, the descriptions of current economic conditions are likely to note the slowdown in business investment and job gains”, Credit Suisse muses, before noting that with “economic activity still growing at a strong rate, we do not see such changes leading to any deviation from the current path of policy [and] the economic outlook of ‘roughly balanced’ risks and ‘further gradual increases’ in rates should remain in place.”
Iran sanctions and the ghost commander
Although the midterms and the Fed will grab most of the attention stateside, sanctions on Iran go into effect from 11:59 Sunday.
This has already turned into a farce. Last week, Trump quite literally made a poster of himself using the Game of Thrones font and posted in on Twitter.
Not to be outdone, the incomparable Qassem Soleimani (commander of the Quds Force) made his own Game Of Thrones poster and plastered it on his Instagram:
That was accompanied by the following message:
Come! We are waiting. I can stop you. Quds Force can stop you. You start this war, but we will finish it.
If you know anything about Qassem Soleimani, the idea that he is being challenged by Donald Trump, a man who racked up multiple military deferments for “bone spurs”, is so laughable that it boggles the mind.
That’s not say that I’m “pro-Qassem”, it’s just to say that Soleimani is a legend; a ghost story; a larger-than-life figure in the Mideast. His fingerprints have shown up on everything from Putin’s intervention in Syria to the infamous kidnapped Qatari falconry party that purportedly helped spark the Qatar embargo last year, to the rather embarrassing seizure of Kirkuk. His military record and influence over regional affairs are the stuff people write books about. So, the notion that “cadet bone spurs” (to quote Senator Tammy Duckworth) is trying to intimidate Soleimani on Twitter using a Game of Throne meme isn’t so much surreal as it is downright stupid.
The reason I bring this up is because Soleimani’s retort (which I’m 100% sure was more an effort to troll Trump than it was an actual threat), is indicative of the fact that this was never about nuclear weapons. That’s something we’ve reiterated in this pages on too many occasions to count. Effectively, the Trump administration is selling a plan to halt the spread of Iranian influence as a plan to punish Iran for nuclear ambition. The problem is that it isn’t at all clear Tehran actually has much in the way of nuclear ambition and to the extent they do aspire to obtain a bomb, they seemingly aren’t trying as hard as they were before the JCPOA. That, in turn, means that exiting the deal is probably a bad idea because it risks a scenario where an irritated Iran begins to pursue nuclear weapons again, putting the entire world at risk and leaving Israel and the Saudis no better off than they were before in terms of security.
As discussed at length earlier this year, cutting off the flow of U.S. dollars to Soleimani (the mastermind of Iran’s regional activities) is impossible. Here’s a passage from a Washington Post article about the infamous kidnapped Qatari falconry party (mentioned above) which serves as a true testament to Soleimani’s creativity when it comes to using his pull in the region to raise funds:
But the conversations and text messages obtained by The Post paint a more complex portrait. They show senior Qatari diplomats appearing to sign off on a series of side payments ranging from $5 million to $50 million to Iranian and Iraqi officials and paramilitary leaders, with $25 million earmarked for a Kata’ib Hezbollah boss and $50 million set aside for “Qassem,” an apparent reference to Qassem Soleimani, the leader of Iran’s Islamic Revolutionary Guard Corps and a key participant in the hostage deal.
Apparently, Soleimani got twice as much in ransom money as Kata’ib Hezbollah, even though Kata’ib Hezbollah carried out the actual kidnapping (on Soleimani’s orders, of course).
That underscores the futility of Trump’s move to exit the nuclear deal. It won’t achieve anything in terms of curtailing the Quds, but it will risk prompting Iran to restart their nuclear program and, less importantly, it risks driving up oil prices.
Well, speaking of oil prices, Trump got “lucky” last month when a combination of generalized risk-off sentiment, a rising dollar, concerns about the outlook for global growth and rising U.S. crude stockpiles led to a dramatic selloff just in time for the midterms.
That gives the U.S. President some cushion when it comes to going ahead with the reimposition of sanctions on Iran without triggering a sharp rise in prices at the pump.
Whether or not the rout in crude can persist in the face of lost Iranian barrels is the subject of vociferous debate. Washington’s decision to grant exemptions to eight countries is obviously bearish for prices in the near-term, but it’s certainly possible that oil has fallen too far, too fast, especially considering the scope for a deterioration in relations between the U.S. and Saudi Arabia if Congress pushes for sanctions in response to the murder of dissident journalist Jamal Khashoggi.
Read our full preview of the Iran sanctions
Trade on, trade off
The trade war will also be in the headlines following last week’s schizophrenic messaging from the administration. Last Monday, reports suggested that if there’s no breakthrough when Trump and President Xi meet at the G-20, the U.S. will publish a list in conjunction with tariffs on the remainder of Chinese imports.
Fast forward to Thursday and Trump was tweeting about a “very good, very long” phone chat he had with Xi. On Friday, a Bloomberg story that said the President had instructed his cabinet to draft a truce sparked a ridiculous rally in Asian equities, with the Hang Seng and the Kospi rising the most in seven years. The yuan, meanwhile, logged a two-day gain so anomalous, it qualified as a 6+ standard deviation event.
It’s against that backdrop that we’ll get China October FX reserves this week, which will give everyone a (somewhat naive) read on capital flight (or a lack thereof) and perhaps hint at PBoC intervention to postpone the yuan’s date with a 7-handle.
“We expect China FX reserves for October to show further evidence of FX interventions, as the PBOC has increased its rhetoric against currency weakness”, Barclays wrote on Sunday, on the way to estimating that China’s FX reserves declined “by USD40bn to USD3.05trn [last month], given likely capital outflows and a negative valuation effect from a weaker Euro.” Consensus is $3.09 trillion, for whatever that’s worth.
Also on deck is China’s October trade balance. You’ll recall that exports held up surprisingly well in September thanks, one assumes, to a mad dash to get out ahead of the tariffs. September was the second consecutive month that saw Beijing log a record surplus with the U.S.
The fresh read on China’s economy comes after last week’s PMI data disappointed and amid escalating talk of a “synchronized global slowdown.”
Watch your lira
In other news, inflation data out of Turkey is comin’ in hot (probably literally). That has the potential to derail Erdogan’s recent momentum. The lira has erased almost the entirety of the August panic collapse thanks in part to a lifting of U.S. sanctions and the generalized perception that the Turkish autocrat somehow managed to escape from the brink of economic calamity to reclaim control of the narrative.
And so, as the eyes of the world turn to the U.S. ballot box, I’ll leave you with the immortal words of Jackie Moon: “Let’s vote, and then we’ll fight”…