Ambiguous Ambiguity

When it comes to US equities and a prospective Joe Biden administration, the debate has always centered around the trade off between predictability and a platform that’s optically less market friendly than Donald Trump’s somewhat bizarre brand of supply-side populism.

This is difficult to tease out, because while many market participants are (still) quick to say that Trump’s policies are unequivocally more conducive to rising stock prices, it’s not clear that’s actually true.

For one thing, Trump prides himself not just on unpredictability, but on coming across as literally insane. And please, I implore you, don’t immediately write that off to partisan editorializing. Recall, for example, the tale of Trump “coaching” Bob Lighthizer on how to negotiate with South Korea, as recounted by Axios in October of 2017:

“You’ve got 30 days, and if you don’t get concessions then I’m pulling out”, Trump told Lighthizer.

“Ok, well I’ll tell the Koreans they’ve got 30 days”, Lighthizer replied.

“No, no, no”, Trump interjected. “That’s not how you negotiate. You don’t tell them they’ve got 30 days. You tell them, ‘This guy’s so crazy he could pull out any minute'”.

“That’s what you tell them: Any minute”, Trump continued. “And by the way, I might. You guys all need to know I might. You don’t tell them 30 days. If they take 30 days they’ll stretch this out”.

“You tell them if they don’t give the concessions now, this crazy guy will pull out of the deal”.

Funny? Absolutely. As long as you’re talking about a relatively small trade deal with an ally like Seoul.

But when you start talking about, for example, denuclearization talks with Pyongyang or, say, a much larger trade deal with an antagonist (e.g., China), then that approach becomes dangerous and vexing for risk assets like stocks.

Of course, outside of the pandemic collapse and a meltdown in Q4 of 2018, equities have done well under Trump, thanks in no small part to his corporate tax cuts and the buybacks they helped catalyze. But it has never been clear that Trump’s economic policies are, in fact, preferable (see the figure below) especially not when mixed with his immigration stance (a long-term economic negative dressed up as a near-term “fix” for stagnant wages) and his penchant for being “this crazy guy”.

So, when it comes to November, nobody is quite sure what to make of a prospective Biden landslide. On one hand, equities would need to immediately price in the mechanical hit from higher corporate taxes, especially if the Senate flips.

“As proposed, the Biden corporate tax plan would arithmetically reduce S&P 500 2021 earnings by roughly 9%, excluding any potential second-order impact from economic growth, business confidence, or other factors”, Goldman wrote, in a note dated September 17. “Of this $14/share impact, roughly half is due to the proposed hike in the statutory domestic rate”.

That said, over the longer-term, Biden’s fiscal policies could actually increase corporate earnings, a scenario the bank’s David Kostin outlined this week.

Adding to the ambiguity is the possibility that the unwinding of “doomsday” hedges tied to the view that the election is sure to produce a contested result, could end up slingshotting stocks higher in a Biden landslide. Nomura’s Charlie McElligott discussed that possibility on Tuesday.

All of that to say that the same kind of ambiguity exists on the rates side. This was the subject of a Bloomberg piece published on Tuesday. Essentially, it boils down to this: In a Democratic sweep scenario, long-end yields “should” rise on the prospect of additional fiscal stimulus, higher spending, wider deficits, and more borrowing.

And yet, there are two potential problems with that. First, Trump could contest any outcome, even one that appears indisputable. He recently told supporters, for instance, that the only way he could possibly lose is if the vote is “rigged”. Second, the risk-off impulse from equities pricing in higher corporate taxes and an optically less market/growth-“friendly” environment (remember, investors don’t generally understand that demand-side stimulus is almost always more effective at juicing growth than supply-side gimmickry) could see the long-end bid.

For now, the somnolence (i.e., sideways drift) in yields at least partially reflects this ambiguity. “The notion that rates are in a holding pattern certainly resonates, even if the process of habituation could serve to limit any potential backup in rates once the near-tern uncertainties are resolved”, BMO’s Ian Lyngen, Jon Hill, and Ben Jeffery said Tuesday. “By consolidating in the 60-70 bp range, such a departure point limits the odds 10s make it beyond 1.00% before material buying interest emerges”.

For Goldman, a Democratic sweep could push 10-year yields higher by 30-40bps. That sounds like a lot, but in a testament to the quote above from Lyngen, even 40bps would still only put us at ~1.04%, not exactly “juicy”, but surely enough to bring in the dip-buyers in a world where a 40bps cheapening would seem like the opportunity of a lifetime for anyone looking to add duration.

Complicating this further is the fact that, as discussed here, Biden’s platform hardly counts as “radically” expansionary. Sure, it’s vastly preferable to Trump’s approach in terms of being redistributive and demand-focused, but Joe is no AOC.

Underscoring the ambiguity is Gregory Staples, head of fixed income at DWS, who spoke to Bloomberg. “A mandate to significantly stimulate fiscally would possibly scare bond vigilantes, steepening the yield curve”, he said. “I don’t view this as likely, but we are confronted with multiple scenarios”.

Yes, we sure are. And let us not forget that irrespective of what policymakers have planned for growth, the virus may have other plans. Even if a vaccine is expeditiously distributed, the damage COVID-19 has already done may be underappreciated. Potential growth may be permanently impaired. We just don’t know yet. Remember: Republicans, Democrats, and the Fed all claim they’re going to bring about an economic renaissance, but nobody other than hardcore Progressives has presented a plausible path to a high octane future for the economy.

“‘Blue wave’ expectations on the back of a strong Biden debate performance might boost fiscal hopes, but the biggest fiscal stimulus is behind us”, BofA’s Michael Hartnett wrote late last week. “Without explicit MMT, it’s hard for policy to catalyze a big upside for stocks and credit in the next six months”.

You could say the same thing for yields. Without explicit, aggressive coordination between monetary and fiscal policy to bring about transformational change (e.g., big infrastructure), it’s going to be hard to get a sustainable back-up at the long-end.

“Looking at election event risk in USTs/rates, the market is actually hedging more for a potential ‘blue wave’ risk scenario, with puts over calls and expressions of steepener options to protect current longs in duration / flatteners”, Nomura’s McElligott said Tuesday. The market’s thinking, he wrote, is that even if a blue wave triggers an initial risk-off move and attendant bull-flattening, there will likely be “a second move / sequencing risk medium-term” where Biden, with a Democratic Senate and House, ushers in “a whole new world of deficit spending with low barriers to unprecedented fiscal stimulus [from] UBI to infrastructure”.

I personally doubt that a Biden/Harris administration will usher in anything all that “unprecedented” economically. I think the best we can hope for is that they lay the groundwork for future administrations to pursue the types of policies that will at least make America’s bridges and roads safe, if not put a probe or two on Venus.

Read more: MMT Is From Venus