This week’s U.S. midterm election provided something for everyone. Each side can claim victory or lament defeat, but the most pronounced reaction may very well be relief. Democrats are relieved that they won’t have to go for another two years without a majority in any part of the federal government. Republicans are relieved that they maintained control of the Senate with a few more seats. 1 1 Close As of 11/8/18, Republicans had picked up two seats in the Senate with results in Arizona and Florida yet to be finalized. Forecasters are relieved they more or less got the results right after some well-publicized misses. Market commentary writers are relieved that they have something new to discuss this week without having to cover Brexit again.
It is difficult to evaluate market reactions when looking across different asset classes. The moves don’t always tell a coherent story, and the initial reaction can be misleading as we all remember from the presidential equity reversal 2 2 Close After the 2016 US election, stocks initially sold off but then reversed and rallied through much of the rest of November. two years ago. Part of the reason is that any new set of elected officials brings in a variety of new proposals, but investors don’t know which, if any, will ultimately be passed. This week, trading the uncertainty of an election for an equally uncertain policy mix was surprisingly reassuring for equity markets. Of course we will never know for sure what the causes of the market reaction really were but an examination of some possible narratives may give us some insight as to what we may see in the coming months and years.
The initial market reaction was a peculiar combination of stronger stocks, a flattening yield and a moderately weaker dollar. 3 3 Close The S&P 500 rose over 2% on November 7th, the first day of trading after the midterm election. 2-year Treasury yields rose nearly 2.9bps, compared to a 0.8bp rise in 10-year yields. The Dollar Index fell 0.1%. Pricing data from Bloomberg. Several economic stories could explain this, such as lower long-term inflation expectations or a reluctant but ultimately dovish central bank, but none of them seem to fit with the election results. 4 4 Close Or at least you would have to really stretch to come up with a connection. Like the divided Congress means that grocery stores will lower prices. Much of the financial news coverage described the election results as ushering in a new era of “gridlock.” Gridlock refers to inaction by a divided government whose factions are unable to cooperate. Some market participants think gridlock is good for stocks and bonds because it prevents either party from spending excessively on its pet projects and inadvertently creates more fiscal responsibility. This idea may come from a cynically American view of government—that politicians hurt the economy when they do things.
Right now the relationship between gridlock and markets is a bit more nuanced. In the past few years, U.S. equity markets haven’t seemed all that concerned with deficits, instead focusing on growth, while the U.S. dollar and bonds have been the hall monitors on fiscal discipline. For example, after the tax plan was released last year, stocks rallied partly on corporate tax cuts, while the dollar and bonds did not perform all that well. 5 5 Close In the month following the signing of the Tax Cuts and Jobs Act on 12/22/17, the S&P 500 rose 5.6%, the Dollar Index fell 3.1%, and 10-year Treasury yields rose 17bps. Pricing data from Bloomberg. The dollar and bonds may have been responding to increased funding needs because of potential future deficits. It’s unlikely equity investors have all of a sudden become the stewards of responsible spending while the U.S. dollar wants growth at all costs.
However, there are facets of gridlock that are good for stocks even if it may mean less stimulus. Some investors feared that a newly-elected, united Democratic Congress might become more aggressive on regulation, reversing the trend of the past few years. With a split government, regulation will likely still be driven by the agencies in the executive branch. Committees in the House of Representatives may call in the leaders of the agencies to explain their actions, but this probably won’t result in meaningful new legislation or a change in the approach to enforcement. Equity investors have good reason to think that the environment will remain business and market-friendly.
Some commentators have also suggested that the split government may ease trade tensions. The speculation is that the administration may not want to pursue an aggressive confrontation with China without support from Congress. An end to the trade conflict would probably be good for stocks and bad for the dollar, so it does at least partially fit the market reaction. The stock market would prefer less uncertainty on trade, but trade measures are generally considered positive for the currency if they reduce current account imbalances or if they mean others will try to retaliate with a weak currency policy. Unfortunately, this may be more wishful thinking than reality. Trade is an area where the executive branch has a fair amount of power to negotiate and enforce deals, even if Congress must approve them. Early indications coming from a famous Twitter account were difficult to decipher. 6 6 Close @RealDonaldTrump tweet on trade: “Received so many Congratulations from so many on our Big Victory last night, including from foreign nations (friends) that were waiting me out, and hoping, on Trade Deals. Now we can all get back to work and get things done!”
The main takeaway from the past few days is that even though market participants only had vague fears about the election, they are happy it has passed relatively uneventfully. There was nothing in the results that would cause people to significantly rethink their views. This feeling of relief probably best explains the market reaction. Looking forward, trade will remain a key issue but not the only one. There are some areas where both houses of Congress and the President could agree. The most likely place would be on increases to spending on projects that both parties like. The long-dead infrastructure spending plan may return as it has appeal to both sides of the aisle, and it could provide some of the stimulus that equities seem to like so much. Mortgage or healthcare reform are always out there, but there is no assurance anything will pass. If we do end up with a long period of acrimony with little legislation, markets will be driven by factors like economic data, earnings and the Fed. Maybe that isn’t a relief.
What We Are Watching
U.S. CPI (Wednesday) As unemployment has fallen to low levels over the last couple of years, investors and policymakers have been on the lookout for signs of improvement in wage growth. In recent months, data has finally begun to indicate a meaningful pickup in wages, with two high-profile measures (Average Hourly Earnings and the Employment Cost Index) showing compensation growth hitting new cycle highs around 3%. 7 7 Close Bureau of Labor Statistics (BLS). Moving forward, the key question for markets and the Fed will be whether higher wages begin to fuel a broader rise in consumer price inflation. The CPI has recently been around levels consistent with the Fed’s inflation target, and has actually shown a slight downtick over the last couple of months. 8 8 Close The Fed targets inflation of 2% as measured by a different indicator called the PCE Deflator, which tends to run a few tenths of a percent below CPI. Last month, for example, the CPI rose 2.3% YoY while the PCE Deflator rose 2.0% YoY. Data per BLS and Bureau of Economic Analysis (BEA). However, businesses facing higher costs for labor and other inputs (such as manufactured goods impacted by tariffs) may face increased pressure to raise prices. Indeed, anecdotal sources such as the Fed’s Beige Book have already begun to describe this dynamic. 9 9 Close Federal Reserve Beige Book, 10/24/18. If CPI data begins to accelerate, it may motivate more hawkish guidance from the Fed, which could be a headwind for both stocks and bonds.
China Fixed Asset Investment, Retail Sales, Industrial Production (Wednesday) Chinese growth has slowed in 2018, 10 10 Close GDP figures published by the National Bureau of Statistics decelerated from 6.8% YoY in 4Q17 to 6.5% in 3Q18. as the country has faced tighter domestic credit conditions and disruptions to its trading relationship with the United States. Uncertainty over China’s economic outlook may have played a role in recent equity market volatility, as investors have been unsure how significant a downturn to expect in the world’s second-largest economy. This week, the National Bureau of Statistics will publish data for three of the more widely-watched monthly activity indicators: fixed asset investment, retail sales, and industrial production. If these figures point to continued deterioration in Chinese growth, it could weigh on prices for Chinese equities and commodities sensitive to Chinese demand.
Mexico Central Bank Meeting (Thursday) Political uncertainty has been an important driver of volatility in the Mexican peso over the last couple of years. One source of uncertainty, negotiations over changes to NAFTA, has waned following a recent deal on modifications to the free trade agreement. However, markets are now growing increasingly concerned about the trajectory of domestic economic policy under president-elect Andrés Manuel López Obrador (AMLO). While AMLO struck a reassuring tone after his election in July, his recent decision to halt construction of a new airport near Mexico City following a hastily-arranged referendum triggered a sharp selloff in the Mexican peso. 11 11 Close Bloomberg: “Mexico's AMLO Scraps $13 Billion Airport Project; Peso Plunges,” 10/29/18. This week, the Mexican Central Bank will decide whether higher interest rates are needed to stabilize the currency and prevent a rise in inflationary pressure. A forceful response could help the peso recover its recent losses.