Does the US midterm election change anything for equities?
Head of Equity Strategy
The US midterm election is done and polls where shockingly and finally right in their anticipation of the election outcome. Democrats grabbed the majority in the House while the Republicans defended their majority in the Senate. Overall, the election is somewhat neutral for equities as the US Congress is split, although we are seeing strong European equity markets today, likely tied to the idea that a split Congress will deliver a sweetener in an upcoming trade deal.
A split Congress will end Trump’s momentum but not stop his foreign policy on trade. The most important takeaway from the election is that the Democrats have aligned with the Republicans on the China issue (so no big change here) and the Democrats would like to spend money on infrastructure (like the Republicans) while probably not daring to touch the recent tax reform.
This leads to two things: The US-China conflict will persist and have an impact on markets. Secondly, the US budget deficit will continue to accelerate into 2019. The post midterm election political landscape might also bring gridlock and another fight over the debt ceiling and potential subpoenas of Trump’s tax records which could be a nasty distraction for investors towards the 2020 general election.
What matters to markets
Zooming out from today’s apparent higher equities and lower interest rates, the world is still facing three critical risks: 1) the Fed and US debt, 2) US-China relationship, and 3) Italy’s confrontation with EU.
With equities on firmer ground the Fed will feel confident to deliver another rate hike in December. The neutral rate is still far ahead of us if the Fed chairman is to be believed. This means an additional three rate hikes next year, sending the Fed Funds Rate above 3% This pushes up the funding costs for the US Treasury at a time when the deficit will widen further due to the tax reform.
But already now the cost of servicing the US Treasury debt is surging to $548bn in October, which corresponds to around 2.7% of nominal GDP and 16.5% of the current budget. With several trillions of Treasuries rolling over the next two years this servicing cost will go up – maybe double? The recent peak in servicing cost was in the early 1980s with the interest cost around 4% of nominal GDP. At one point this will spook the market and the fundamental issue is that the USD is the global reserve currency. The world is literally running on USD and unfortunately the world has borrowed too much of it after the great financial crisis.
Italy is an existential risk to the EU project. It’s simply too big to fail. As a result the EU is likely to strike a deal with Italy but not until the market has disciplined Italy to climb down from its pedestal. That means markets will get fresh injections of volatility as news will evolve on Italy until we get a deal. While Italy is a key risk it is also a potential outrageous trade idea. In a Goldilocks scenario Italian equities could be 30% higher within the next nine months. All it takes is: 1) Brexit deal, 2) China succeeds in stimulating its economy, 3) potential soft deal between the US and China, 4) The ECB chooses a slightly more dovish path through 2019, 5) Italy strikes a deal with the EU and 6) the global economy stays robust.
Our equity views
As communicated in our Q4 Outlook and recent presentations, we are negative (underweight) US equities due to valuations and positive (overweight) Europe and China. Our dynamic asset allocation model Stronghold has reduced equity exposure to around 35% which is conservative. Any equity exposure should be defensive or tilted towards minimum volatility factor. Be prepared for a volatile 2019 where the US debt/deficit issue will potentially spook markets and the Fed is overshooting on rates.
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.