Biden bounce - Risk and Opportunity
Summary: Trump is yet to concede defeat but Joe Biden has won the US Election and the incoming Biden administration has begun planning for a Biden presidency ahead, adjusting for the prospect of a divided government. Markets are taking this in their stride and the Biden bounce has extended. What comes next?
For risky assets craving certainty, fresh off the win, Asia’s markets are extending last week’s gains and leading the charge in post-election euphoria. The unwinding of protective hedges as the event risk has passed contributing to upside momentum. However, with the election out the way, it will get tougher from here as markets are likely to shift focus to the stimulus stalemate, COVID-19 containment problem and the January run-off senate elections in Georgia. The ability for markets to “look through” the worsening pandemic outlook is lessened by the lack of a robust fiscal stimulus package in the US and little progress in virus containment, however stimulus hopes keep upside in play.
Despite certainty on the election front, there remains a wide dispersion of outcomes, with the current virus spread posing downside risks, but on the flipside the prospect of containment or a safe vaccine presenting upside. Equity markets in particular have the luxury of "looking ahead" - fiscal stimulus, a vaccine rollout in 2021 and continue easy policy perpetuated by central banks is still a powerful cocktail for risk assets to keep heading higher.
The Deflation Rotation
Unabated risk-on sentiment has continued this morning and in particular, growth stocks are back in vogue and NASDAQ futures continue to soar, relishing the prospect of a divided government limiting reflationary upside given diminished fiscal prospects. The “lower for longer” expectations benefitting long duration assets (technology and growth stocks).
The Democrats retained control of the House of Representatives but gave up seats, with the Republican Party improving their position and likely maintaining control of the Senate dashing hopes of a “blue sweep” majority in Congress. The prospect of gridlock bringing reduced risk of sweeping legislative changes like monopoly crackdowns/anti-trust scrutiny, tax hikes and progressive left agendas – a net positive for equities.
A Biden administration would likely maintain trade policy that remains tough on China but is less volatile and more collaborative than the last 4 years of the Trump administration has seen. With Biden taking a more multilateral approach and working with US allies, finding strength in numbers. A more predictable approach to foreign policy and the possibility of tariffs on Chinese imports being wound back coupled with strong risk sentiment and broad USD weakness contributing to solid gains across the ASIA FX and equity spectrum, which have extended today. In addition, the PBOC strengthening the CNY fix today vs. Friday providing further impetus for an extension of ASIA FX strength and softer USD. Robust global risk sentiment, Yuan strength, and stronger global commodity prices also supporting the risk sensitive, China proxy AUD.
More broadly for Asian assets, as highlighted last week, the regions better management of the pandemic and ongoing reopening/economic recovery continues unhindered by resurgent COVID-19 cases, setting a divergent path relative to the US and Europe. With the event risk of the election now passed and less foreign policy uncertainty likely to be characteristic of the incoming Biden administration Asian equities have scope to outperform. Less volatility in US/China tensions and the continuation of China’s recovery also benefitting the region as an engine for growth. Alongside the aforementioned factors, the catalyst for a move higher toward year-end is in play - South Korea, Japan, China, Taiwan all attractive within the broad Asia region.
For Australian stocks, with the ASX 200 index having been stuck in tight range for months, the confirmation of a supportive budget, further easing from the RBA and sustained progress in containing the virus in Victoria, with borders on track to open and restrictions easing provide support for the index to breakout. Now with the added certainty on the outcome of the US election combined with the continued reopening of the economy, a pro-business budget and the governments increased fiscal firepower relative to the US and Europe still in throes of a 2nd virus wave provide ongoing support for Australian stocks to break higher.
With the election out the way, markets are likely to shift focus to the stimulus stalemate, COVID-19 problem and the January run-off senate elections in Georgia.
Republicans look set to retain a small Senate majority; moreover, they sliced into the Democrats’ advantage in the House of Representatives. However, there is still some uncertainty on the composition of the Senate, which will be key for fiscal expectations and maintaining the “lower for longer”, no tax hikes duration play that has seen technology stocks soar in the wake of the election.
We will not know for sure who has control of the Senate until run-offs in Georgia in January. Although the Republican candidates are favoured, and in prior run-offs in Georgia in 2004, 2008 and 2018 Republican candidates have won the Senate seats, there is still a small chance of the reappearance of the “blue wave” trade.
With Republicans retaining control of the Senate, the prospects of a deal on a large stimulus package are diminished. The $2trn plus that was on the cards under the blue wave could be as small as $500bn with an obstructionist Senate.
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. In addition, no tax hikes or Trump shock factor – Biden is predictable and has not 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 in the throes of a global 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 prospects of a lame-duck deal being reached prior to Biden’s inauguration are slim, and the chances of a large stimulus package even post inaugurations are slimmer. On Friday, Senate Majority Leader Mitch McConnell doing little to recoup expectations for enacting a larger package, "Our economy is really moving to get back on its feet. That I think clearly ought to affect what size of any rescue package we additionally do." It seems that unless the economic need becomes quite dire, a large package is not coming.
But prevention is always better than the cure, and 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. Even more so if the COVID-19 case count continues to accelerate. Recovery momentum will wain further as the stimulus gap weighs which should give risk assets pause for thought.
The COVID-19 Problem
COVID-19 cases continue to surge in the US and just as the election has drawn to a close the US has set fresh records for daily infections.
The bumper gains following Biden’s victory could be vulnerable to a corrective move with the resurgence of the virus and its impact on already plateauing economic recoveries where the stimulus impasse is set to weigh on the outlook for growth. Whilst we remain constructive in the medium term, we are wary of the potential for whipsaw moves given the global economy remains in a fragile state and the pandemic outlook continues to worsen. A correction prone rally with the stimulus stalemate and lack of COVID-19 containment putting reflation on ice.
Vaccine - Factor Volatility Incoming
Further outsize moves – from Asia FX, to EM equities and cyclical stocks, to commodities – will likely be dependent on the timing of a vaccine, which would be a catalyst for cyclical rotation.
The next big trade will be the rotation trade, as markets look ahead to a continued normalisation of the global economy, toward assets that will outperform on recovery vs. those where performance has been front-loaded. However, the saturation point of the "stay at home" trade is highly dependent on the pandemic and containment of the virus/timing of a vaccine. The digital economy, where gains have been front loaded, will not be the outperformer as the economy reopens. Opportunity is now weighted toward pro-cyclical stocks where the risks of overly crowded positioning and excess speculation are not prevalent and the valuation/expectation starting points provide a better outlook for gains. With rotation a proxy for economic optimism, this is where the next bout of outperformance arises. Travel, leisure and "going out" stocks have the most delta on activity normalising, followed by energy, materials and industrials, and financials.
Without the aggressive reflationary stimulus package that could have accompanied the “blue sweep” containment of the virus will be critical for the cyclical pivot and reflation trades. The biggest influence on the recovery is success in containing COVID-19.
A number of vaccine trials will be updating toward year end, so watch out for any news on a safe vaccine. Although there is clearly a lag between having an effective vaccine and administration, risk assets will still react. Although, there is a huge amount of uncertainty between the timing on a vaccine and the current rising case count/stimulus stalemate, which sees heightened volatility remaining part of the picture.
Fed Back in Play
Clearly risks remain. Namely, the stimulus impasse and the continued acceleration of COVID-19 cases in the US and Europe. With these factors in play, focus then shifts to the Fed.
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 their next meeting in December, including purchases of longer dated maturities.
The Fed have a long way to go in meeting their full employment and inflation mandates and 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 for risk assets, we know the drill!