With the US midterm election results in, the biggest surprise was that for once the polls were right, after getting Brexit and the US presidential elections wrong! As expected, Republicans kept the Senate and Democrats took the House. Despite being expected, the removal of the uncertainty discount and “blue wave” risk has been a positive for risk assets with US indexes all in the green overnight and Asian indexes breathing a sigh of relief today.
With the immediate reaction out the way, markets will look ahead, focusing on fundamentals (growth, inflation, and Treasury yields) and the upcoming meeting between Trump and Chinese president Xi Jinping at the G20 summit.
Gridlock is good?
The equity markets have taken comfort from the Republican Senate majority, meaning the risk that corporate and other tax reductions will be reversed is unlikely.
The split Congress likely means a pause on major policy changes and fiscal initiatives. The stimulatory tax cuts 2.0, which would have provided a fiscal boost, are dead in the water now. Although they may not have been equity market positive as they would have resulted in a more hawkish Federal Reserve increasing rates further. Consumer tax cuts would have been more inflationary and less productivity-boosting than the corporate tax cuts enacted earlier in Trump’s presidency.
The pause on fiscal spending has allowed markets to breathe a sigh of relief due to the potential moderating in ever increasing US deficits, and the possibility of a less aggressive Fed next year. This is reflected in the initial downwards movement in long end rates and the USD.
A stimulative bipartisan bill on infrastructure could still be happen and is completely necessary for anyone long US industrials at this point in time. An infrastructure bill appears to have broad support, but the problem arises in how to fund it. At any rate, the $1 trillion bill that was promised in Trump’s election campaign is highly unlikely.
Where to be wary of the 'gridlock is good' thesis
The Democrats are likely to be emboldened and to use their House majority to investigate Trump, thus increasing political uncertainty. Democratic House committee chairs will now have subpoena power, which they are highly likely to exercise. Tax returns, business dealings, Comey’s firing, dealings with Russia, and anything else that could be used to tarnish Trump’s image are all possibilities. This could be an ugly distraction for equity markets throughout 2019.
With Trump unable to push through any further stimulatory measures but able to impose populist trade tariffs without congressional approval, his focus may be focused firmly on the latter. With this is mind we could see a more aggressive stance against China and an escalation in the unfolding trade war.
For the market now, it is likely that in hindsight the midterms are a non-event as focus shifts to economic fundamentals and the upcoming meeting between Trump and President Xi at the G20 summit.
The upcoming G20 meeting at the end of this month will be for crucial markets to assess the current state of the US/China trade relationship. There has been a great deal of speculation since last week, after Xi and Trump’s phone call, that a deal may be struck at the G20. Recent comments in President Xi’s speech at the Shanghai Import Expo did not sound like Chinese leadership are on the verge of satisfying the US administration’s demands, with Xi singling out US “law of the jungle” trade practices.
These condemnations, along with nothing concrete in Xi’s speech to satisfy US trade hawks, do little to reassure the more optimistic camp of speculators. However, with China’s top foreign affair officials travelling to DC this week, the situation is certainly the most constructive it has been for a while.
If progress emerges from these talks and Liu He – China’s Vice Premier, top trade negotiator and Xi’s top economic advisor – travels to Washington, we can expect the markets to get excited.
We’re not hopeful for any US/China trade deal beyond a ceasefire or tariff truce pending negotiations further down the track.
Critical risks for markets, other than the trade wars, still exist regardless of the midterm elections. The Fed’s rate hiking trajectory with higher bond yields calling into question equity market positioning, the outlook for global growth and inflation and the Italian governments confrontation with the European Union will all continue to weigh on equity market sentiment.
We expect volatility to remain elevated as markets struggle with an ugly cocktail of geopolitics, populism, and rising interest rates. Investors will be rewarded for positioning cautiously against this backdrop and overweighting defensive sectors within equities and in terms of factor exposure, tilting towards low beta/minimum volatility, quality, and value as we see a continued rotation out of growth, momentum, and high-beta positioning.
2019 has the potential to be a tumultuous year for all asset classes with maximum Fed tightening, draining dollar liquidity, and rising interest rates. Volatility will likely increase in intensity as the Fed moves further into a financially restrictive phase throughout 2019.