Per Stirling Capital Outlook – October
With the election now only one week away, this will be the last Outlook that concentrates on this contentious subject. At least, the equity markets had better hope that is the case because, if the election is still a point of significant uncertainty and market relevance a month from now, we would anticipate that we will be in the midst of a temporary rotation out of risk assets and into safe harbor assets that would likely cause interest rates and equity prices to move lower and bond and gold prices to move higher.
This is admittedly a short-term call, as our market outlook prior to the determination of the election results is decidedly different from our outlook for the markets once we have clarity on the elections, and a clear understanding of the composition of the federal government for the next two or more years.
For the record, we believe that the equity markets, in particular, are largely indifferent to the election outcome (at least, once that outcome has been decided), and that there are significant reasons to expect the year 2021 to be quite favorable for both the equity markets and the economy in general.
In contrast, while the bond market may also be rather indifferent to the outcome of the presidential election, due to the fact that both candidates favor a further explosion in fiscal stimulus and deficit spending, it is difficult to build a bullish case for bonds once we get election clarity, at which point they are less likely to benefit from their traditional role as a safe harbor during times of uncertainty.
Ultimately, uncertainty is manna for high-quality bonds, but kryptonite for the equity markets, and the potential for uncertainty is, in our opinion, extraordinarily high between now and the ultimate determination of the election results. As noted, we believe that, with one major exception, growth-oriented investors are largely indifferent to the outcome of the election, and are very likely to celebrate quite strongly the removal of this cloud of uncertainty, once the cloud is lifted.
That one major exception is in regards to the pandemic, where the latest ABC News/IPSOS Poll found that “more than 6 in 10 Americans (61%) disapprove of the president’s response to the pandemic, while only 38% approve”, and that 78% of Americans are concerned about getting infected with COVID-19, while only 22% are not.
The pandemic has been politicized since it first hit U.S. shores, and is now arguably the single most important issue in the 2020 presidential election.
Biden is advocating a science-based and national response to the pandemic that is similar to the strategies being employed by many countries in Asia.
In contrast, President Trump has consistently advocated steps to fully reopen the economy and return life back to “normal”, in lieu of contact tracing, expanded testing, mask wearing and other programs designed to mitigate the impact of the virus. Instead, the Trump administration is wholly relying on the development and adoption of an effective vaccine and the continued development of improved therapeutics. This approach was just confirmed by White House Chief of Staff, Mark Meadows, who declared during an October 25th CNN interview that “we are not going to get control of the pandemic”.
The simple fact is that neither life nor the economy will ever return to normal until we get the virus under control. We believe that Wall Street is very well aware of this fact, which is why, according to the Center for Responsive Politics, Wall Street has donated $58 million to Biden and only $14 million to Trump. Also noteworthy is that Biden raised three times more money from wealthy zip codes than did President Trump.
This has not been lost on the American public in general, where a just-released Peter G. Peterson Foundation survey found that “46% of Americans believe Mr. Trump’s policies have actually now ‘hurt the economy’ compared to 44% who said the policies have been helpful. That is a huge shift from the 11-point margin in the President’s favor back in March, before the pandemic really reared its ugly head”. Further, an October 19th survey by Eaton Vance found that 58% of respondents believe that “a victory by former Vice President Joe Biden will send the stock market higher. That exceeds the sizeable minority, 46%, who also think a victory by President Trump will also push stocks higher”. We believe that both perspectives are correct.
Importantly, controlling the pandemic is not just some sort of “pipe dream”. It is being done quite effectively in the Pacific Rim, where both the economies, and life in general, have largely returned to normal. Indeed, according to the Wall Street Journal, “bars and restaurants are bustling, subway trains are packed, and live concerts and spectator sports have resumed”.
As was noted by Ashish Jha, who serves as the Dean of the Brown University School of Health, “If you can control the virus, you can get 95% of your life back…In the U.S. and Europe, we wanted to get our lives back, so we acted as if the virus was under control. In Asia, they were not in denial. They understood that they could have their lives back if they follow certain precautions”.
Despite not employing the kind of broad economic shutdowns that have been used (with disastrous economic consequences in the U.S. and Europe), China, Japan, South Korea, Hong Kong and Singapore combined have, since September, been averaging less than 1,000 new cases per day. This is in sharp contrast to the U.S., which is averaging 60,000 to 70,000 new cases per day, and Western Europe, where the case count is growing at a parabolic rate.
The response in the U.S. and Europe has been to throw money at the economy with both hands. However, until these regions of the world get the pandemic under control, fiscal and monetary stimulus is simply a band-aid being applied to an open wound. Indeed, one could argue that it is not stimulus at all, but is instead simply being used to replace the economic growth and potential that is being lost to this out-of-control pandemic.
That said, it is a very reasonable assumption that vaccines, once approved and broadly employed, will make a substantial difference in the battle against COVID-19. However, a vaccine is unlikely to be a panacea, and there is a growing concern among some on Wall Street that the market is getting too complacent about the availability and efficacy of an eventual vaccine. As was just noted by UBS’ renowned Director of Floor Operations, Art Cashin, “The market action now is not about earnings, it’s about the vaccine and the economy… The problem is, the markets think [a vaccine] is a binary event, like flipping a switch on, and suddenly we are all going to go back into the movie theaters. It may not turn out that way.”
This concern was just echoed by Dr. Fauci, who noted that we don’t know how effective a vaccine will be. “We don’t know if it will be 50% or 60%… I’d like it to be 75% or more but that may not be realistic”.
That said, the markets are clearly counting on a very effective and widely accepted vaccine driving a strong economic and earnings rebound in 2021, with current consensus estimates that S&P 500 earnings will surge by 14% on a year-over-year basis in both the first and second quarters of next year.
If, as we expect, we do get a viable vaccine in 2021, and a vaccine program that is ultimately both widely adopted (a concern, as a recent WSJ/NBC poll reported that only “20% of respondents said they would take a vaccine as soon as one becomes available”), and which helps to catalyze a powerful earnings recovery, it would add to an already substantial list of reasons to be quite optimistic regarding the outlook for the domestic equity markets in 2021.
Other reasons for optimism include a modest, but reasonably sustainable, economic recovery and expectations for a major new fiscal stimulus package that, particularly in the event of a “blue sweep” (with Democrats taking all three legislative branches of government), could equate to about one-tenth of the size of the entire U.S. economy.
Moreover, due to the new modus operandi on the part of the Federal Reserve, which is now willing to let the economy run “hot”, it is probable that, unlike in the fourth quarter of 2018, the Fed is now unlikely to take steps to counter such stimulative fiscal policy through tighter monetary policy.
To put the importance of this last factor into perspective, for decades there have been periods of time when “good news was bad news”. In other words, periods when equities sold off on good economic news, under the premise that it would catalyze the Fed to tighten monetary policy, as part of their practice of proactively snuffing out inflation before it could gain a foothold.
Now that there is presumably much less of a risk of “good news” being perceived as “bad news”, there is also presumably a much greater likelihood that the aforementioned huge dose of fiscal stimulus will be allowed to have its full impact on the economy and corporate earnings. It probably also diminishes, at least for the equity markets, the relevance of most economic data, with the notable exception of the inflation numbers, which we believe would have outsized importance if they manage to break and sustain above 2.5%, as we believe that undesirably high inflation may be the one factor that would cause the Fed to reverse their historic monetary stimulus programs, which have powered both stock and bond prices off of their pandemic lows.
To reiterate an all-important factor that we have discussed in detail in previous writings, and which is probably the only macroeconomic factor that may be even more influential than the pandemic itself, the Federal Reserve, in coordination with the Treasury Department, has flooded the economy with an amount of money that is far in excess of what can be employed in the real economy. Since the vast majority of this liquidity (M2) is not being borrowed and it is not being spent, it has to go somewhere. As per usual, excess money supply tends to flow to “where it is treated best” and, since late March, that has been in the financial markets.
In our opinion, while the Fed has made clear that they want to see higher inflation and higher interest rates, we believe that it is the return of undesirably high levels of inflation that represents the only factor likely to catalyze the Fed to reverse the expansive growth in the money supply, and pull the rug out from under this liquidity-driven bull market in equities.
While we view this change in Fed policy as bullish for equities, particularly once we get past the anticipated election-related uncertainty, it is never a good thing for bond investors when the central bank is actively pursuing policies designed to increase both inflation and interest rates. This topic was addressed in great detail in last month’s report. The current environment for bond investors has been described as “picking up pennies in front of a steamroller” and that “bonds have gone from providing risk-free return to return-free risk”.
Of course, these comments apply to the period of clarity, after the national elections are resolved. In the meantime, an allocation to higher-quality and shorter maturity debt instruments could provide a safe harbor from what could potentially be quite a violent storm. That said, there are scenarios where any election indecision could be removed very quickly, such as an early electoral college result that is so lop-sided for one of the candidates that court challenges and mail-in ballot recounts would be deemed irrelevant and not worth pursuing.
That more optimistic outcome, at least from the perspective of the risk markets, is certainly within the realm of possibility, as Biden still enjoys a quite significant 13% advantage according to the prediction (betting) markets, despite some improvement in Trump’s polling over the past ten days, which we suspect is due to a recent surge in Republican voter registrations.
Moreover, most of the major analytical firms suggest that it will be even more one-sided, with Trump’s odds of reelection ranging from 12% at Five-Thirty-Eight Research to only 7% according to The Economist Magazine.
In contrast, the consolidated national polls suggest that the race is considerably closer, with a spread of only 7%, and there is evidence that the “shy Trump voter”, who will not admit publicly their support for Trump, may carry the day, as they did four years ago.
On top of that, some of the firms, like Expert.ai, that use artificial intelligence to analyze the elections (and which were among the few sources that correctly predicted both “Brexit” and Trump’s victory four years ago), put the odds much closer, at 50.2% for Biden versus 47.3% for Trump.
We suspect that these differences may ultimately prove largely immaterial, as is suggested by a recent comment from Eric Trump, who said that his father would only concede if “he got blown out of the water.” Unfortunately, we suspect that this comment is spot-on, and that the Trump campaign is going to use every conceivable means to challenge any election result other than a Trump victory. Indeed, as was noted by Myrna Pérez, director of the Voting Rights and Elections Program at the Brennan Center for Justice, there will be “no limits to the political hardball” and “no things that are off the table when people are trying to translate votes into political victories.”
Moreover, according to a recent CNBC poll, 37% of respondents are concerned that Biden will not concede if he loses and 49% are concerned that Trump won’t concede if he loses. Further, Matthew Bartolini, CFA, Head of SPDR Americas Research, just noted that “the probability of a 2000-style delay in the 2020 results is high and worth examining, as the market doesn’t like uncertainty — especially when it comes to the presidency… stoking uncertainty in the markets for longer than 2000’s 36 days. After all, unlike in 2000, there likely will be more than just one state with an election outcome in doubt”.
While Biden initially stated, while campaigning in Pennsylvania, that the only way he could lose the election would be because of “chicanery” at polling places, he later clarified that he would accept the results. In contrast, Trump has stated time and time again that “The only way we’re going to lose this election is if the election is rigged” and has also refused to say that he will accept a peaceful transfer of power. Moreover, Matthew Morgan, the Trump campaign’s general counsel, said in a recent statement. “Republicans are preparing every day for the fight and will be ready on Election Day and after.”
Indeed, the odds of a contested election seem very high, and Trump’s best chance of reelection clearly seems to be to push the election decision to either the Supreme Court, where it was decided in 2000, or back to Congress, where it was decided in both 1801 and 1825.
This perspective was reinforced in an interview last month with Senator Ted Cruz, who said that legal challenges “could make this presidential election, drag on weeks and months and well into next year. That is an intolerable situation for the country. We need a full [Supreme] Court on Election Day, given the very high likelihood that we’re going to see litigation that goes to the court. We need a Supreme Court that could that can give a definitive answer for the country.”
Risk markets have historically reacted very negatively to this kind of uncertainty, and legal challenges and ballot recounts may not be the only source of market angst. Indeed, in September, The International Crisis Group, whose job it is to anticipate “deadly conflicts in hot spots around the globe” added, for the first time ever, the United States to its watchlist due to possible election-related violence. In addition, the three major credit rating agencies (S&P, Fitch and Moody’s) announced that they are watching the U.S. elections, and that anything other than a peaceful handover of power could catalyze a review of the U.S. credit rating, which would likely be a significant pain point for the capital markets.
To reiterate, we believe that the equity markets are largely indifferent to the outcome of the elections, and will celebrate election clarity as soon as it is achieved, regardless of who is ultimately in power, and whether the result produces a unified or divided government.
As per the Wall Street Journal, “from 1929 through 2019, one party controlled both chambers of Congress and the presidency in 45 of those years. The S&P 500 on average rose 7.45% during those years, according to Dow Jones Market Data. The index was up 30 times and down 15 times. In the other 46 years when there was a split government, the index climbed 7.26% on average, rising 29 times, falling 16 times and remaining unchanged once”.
Further, according to Bianco Research, “since 1937, the S&P 500 has returned an average of 15.52% under unified governments versus 18.16% under divided governments”.
Bianco Research also points out that, while equity markets are largely indifferent to the composition of the federal government, the same can not be said of the debt markets, which have historically performed much better under divided governments, presumably because unified governments are able to pass through more regulation, and because increased regulation tends to be inflationary, and erode the purchasing power of the fixed income stream that bonds provide.
Indeed, the difference has historically been quite substantial. According to Bianco Research, “the long bond returned a paltry 1.95% [on average] under unified governments versus 14.54% under divided governments”.
Of note, while the polls and betting markets assign a virtually non-existent possibility of a Republican sweep of the White House, House of Representatives and Senate, the betting markets are currently assigning a 58% likelihood of a Democratic sweep of all three branches, which could prove problematic for the debt markets.
In regard to the impact of the elections on the equity markets, we expect for the journey (the election process) to be much more important than will be the destination (the election results). We suggest hunkering down for a bumpy ride over the short term, and looking forward to a much more rewarding environment, once we can put 2020 and all of the election-related angst in the rear-view mirror.