No blue wave, no prob but for how long?

Biden’s wins in Wisconsin and Michigan now mean he has a clear path to winning the Electoral College and is closing in on victory. Meanwhile Trump is launching a legal assault across several battleground states. Markets have taken this in their stride and the rotation trade overnight saw powerful moves in technology stocks that has continued through to the Asia session.

Deflation Rotation

Overnight the curve flattened and growth stocks stormed value as the “blue wave” scenario repriced and investors rotated away from the reflation trade toward the “lower for longer” beneficiaries (tech/growth). Gridlock on stimulus and the Fed now viewed as back in play (a poor substitute for a large stimulus package) driving the deflation rotation.

Diminished prospects of a large stimulus package under a divided government, weighing on yields, whilst long-duration assets that benefit from “lower for longer” were back in vogue. 

In addition, the reduced risk of monopoly crackdown/anti-trust scrutiny and tax increases under a blue wave scenario contributing to the gains. The combination of Senate blocking any substantial tax hikes meaning unchanged tax policy and no risk of a progressive left agenda supporting sentiment.

Legislative Gridlock

Republicans look set to retain a small Senate majority; moreover, they sliced into the Democrats’ advantage in the House of Representatives. With Republicans still bossing the Senate, the prospects of a deal on a large stimulus package are significantly reduced. The $2trn plus that was on the cards under the blue wave could be as small as $500bn with an obstructionist Senate.

Whether this will eventually weigh on risk assets remains to be seen, the overnight gains have been backed up in the Asia trade. Although for Asian assets, with the regions better management of the pandemic and ongoing reopening’s a divergent path is becoming apparent. With the uncertainty of the election removed, once a clean result is confirmed, with the aforementioned factors in play combined to lift investor sentiment, the catalyst for a move higher toward year-end should be in play.

US futures have advanced throughout the day’s trade so for now markets seem to be ignoring this. The narrative appears to be that with Biden + Gridlock a smaller deal will eventually be reached, yields will not push higher as they would have with a larger stimulus package, the Fed will remain in play and rates will remain lower for longer, more QE and liquidity will be incoming and risk assets will be off to the races. Plus no tax hikes or Trump shock factor – Biden is already a bore and hasn’t even taken office yet, markets like that certainty.

Indeed historically, the combination of a divided government has previously been the most positive outcome for the S&P 500. Although the sampling is limited and throughout those periods the economy was not grappling with a pandemic. The COVID-hit US economy is in need of more than a skinny stimulus deal and an obstructionist senate will not be good for growth, confidence or corporate profits.

The stimulus gap and fast approaching benefit cliff with all pandemic related UI programs (PUA, PEUC, etc) set to expire on December 31st presents a concerning dynamic for the US economy. The impasse will be negative for consumption/investment in 4Q20 and well into 1Q21 dependant on the senate race, undermining the 3Q rebound. Overnight, the ADP October jobs report missed estimates by a wide margin, the recovery momentum will wain further as the stimulus gap weighs.

And then there is COVID-19, just as the election has drawn to a close the US set a  fresh record for daily infections. Texas reported the most daily infections since August and New Jersey hit a fresh 5 month high in cases also.

For now, equities are ignoring both COVID and the stimulus impasse, but the options market is not. A look at S&P 500 Dec 3100 puts sees a ~1/5 chance of pay off. 

However post any upset, focus then shifts to the Fed. Do we have to rebuy the put? Perhaps, but we can be certain the Fed will step in if market dynamics turn ugly again.

In fact the diminished odds of an aggressively expansionary fiscal package that Powell and other Fed officials have long pleaded for could see the Fed making policy changes as soon as December, including purchases of longer dated maturities etc.

An expansion of monetary policy measures will be no substitute for a decent fiscal stimulus package. However, the Fed may be left with few options if lawmakers cannot put their differences aside. This is certainly not the best outcome for the real economy, but as we know risk assets love liquidity.

Hence the deflation rotation – the low yield, long duration, stay-at-home trades are back! Reflation trades are likely on pause until there is an update on a vaccine and recovery outperformers may have to wait until we have more clarity on the return to normal.

Contested Result?

Trump continues to sow seeds of chaos and spread distrust in both the Electoral and vote counting process, setting the scene for his loyal base to believe the election victory has been illegitimately claimed by the Biden camp.

This is another factor that could see markets remain on edge, particularly if trump’s diversionist tactics are able to stir up any civil unrest amongst his base. Already a gaggle Trump supporters in Detroit have broken past police and entered a ballot counting center, chanting “Stop the count!”. Against a backdrop of COVID-19 resurgence mounting civil unrest would not be a recipe for restoring business and consumer confidence. Particularly if the next round of government aid is lagging.

However, perhaps markets aren’t reacting yet because it doesn’t seem like Trump has yet  garnered full support for his contest.