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.
