The US Midterms
The outcome of the US mid-term elections, a Democratic win in the House of Representatives and a Republican win in the Senate, was widely expected. Financial markets were nervous before the elections, perhaps fearing a Democratic conversion of the Senate, or fearing general uncertainty as elections have become highly unpredictable of late. The immediate reaction to the outcome was a sigh of relief and a rally in risk assets. The USD weakened as one would expect and the yield curve flattened as demand for haven assets abated.
While the Republicans held the White House, Senate and House, policy making was easier. A Democrat House will mean general gridlock. Infrastructure and anti-China sentiment are the only things that the Democrats and Republicans share but bear in mind that any issue may be drawn into a bigger quarrel. What the Democrats promise is greater checks and balances against the power of the President which will almost certainly mean an end to tax cuts and resistance to further deregulation.
The immediate and perhaps simplistic implications are:
- The cap or end of tax breaks and deregulation are negative for equities and credit.
- The checks and balances on fiscal policy are positive for the budget and positive for US treasuries.
- A more fiscally hawkish stance is less inflationary and will exert negative pressure on interest rates.
- A generally weaker growth forecast will weaken the USD.
In fact the political gridlock will complicate some matters while it makes others clearer. A political stand still will mean that the operating environment is known with more certainty since policy changes will be unlikely. Businesses will be able to focus on growth and earnings. On the other hand, US markets had been discounting further corporate, income and capital gains tax cuts which are now at risk.
The impact on trade is hard to predict. The President does not require Congressional approval and can act almost unilaterally on the trade front, but again, we note that any issue is a potential bargaining chip with the Democrats in the House. Presidents Trump and Xi meet at the G20 and there are hopes of détente on the subject of trade. China has promised pre-emptively and unilaterally to cut tariffs ahead of the meeting which is a positive sign for risk assets, especially China’s.
The November FOMC held little surprise. While November is not a month where the Fed changes rates the message was clear. The assessment of the economy was stable while noting a tightening in the labour market and a softening of business investment, and signalling that policy would stay on course for a rate hike in December. This tightening labour market and softening capex is an interesting observation because it is additional evidence to our thesis about raising rates, that it would increase the cost of investing in capital and cause substitution towards labour. Our thesis further predicts that this mechanism will be the underlying mechanics for the macro phenomenon whereby rising interest rates puts upward pressure on inflation.
In June 2018, the ECB announced an end to QE, when it would stop net purchases of bonds from the end of the year. At that time, we anticipated that the European economy, which had rebounded in late 2016 on the back of a rebound in world trade, would slow once again when world trade decelerated (and this is without even a trade war) and that the ECB would be unable to end QE without replacing it with some other form of policy accommodation. We reiterate this forecast. European PMIs have declined in 8 of the last 10 months. Manufacturing has slowed further than Services. The most recent weakness has been in German PMI, which is worrying as Germany is the powerhouse of Europe.
Italy has resurfaced old problems with a limit testing fiscal budget and intransigence towards warnings from the EU. The ECB will find it very difficult to end QE without re-starting Long Term Refinancing Operations, basically a 3 year repo facility allowing banks to borrow against collateral. No one in the ECB or the EU will say this, but it will allow the ECB to finance private commercial banks to be their proxy buyer of Italian and other peripheral debt in larger quantities than German bunds, something that was prohibited under the QE. Europe wants to kick the can down the road but doesn’t want to be seen to be doing so intentionally. Here is an excellent way of having the private sector kick it for them. If our scenario comes true, the spread between peripheral debt, notably Italy’s, will converge with bunds. The other implication is that it would take the pressure away from Italian banks.