Special Market Commentary – Now What?
By Brian Andrew, CFA® – Chief Investment Officer
While we are still waiting for the election outcome for the House of Representatives, we have a clear picture of who will be in the White House and in control of the Senate. Today’s market reaction is a continuation of the market’s pricing in a former President Trump win over the last several weeks, only on steroids.
First, let’s not let ourselves get ahead of the policy makers. We can make some assumptions regarding future policy based on campaign rhetoric and the former President’s term, though we shouldn’t assume that either represent exactly what’s going to happen going forward. Let’s look at the market’s reaction and the policy issues we should focus on in the future.
Today’s Markets
As I write this, the S&P 500 Index is up 2%, the DJIA almost 3% and the Russell 2000 small cap index 6%. The yield on the 10-year Treasury is up 18 basis points to 4.45%. Gold has declined by 3% or so while the captain of risk-on, Bitcoin, has risen 7%.
Post presidential election, there is almost always a relief rally, and it tends to be stronger when a Republican wins. We can expect this rally to continue through the end of the year. You may recall that since 1900, if a Republican wins, it results in an average 3.5% positive return.
Why the reaction? The increase in bond yields recognizes that campaign promises suggest a potential increase in inflation. Higher tariffs and a reduction in immigration could lead to higher prices. In addition, the economic package released by the former President’s campaign suggested an increase in the deficit of at least $250 billion per year over the next 10 years. Naturally, we will have to see what the future holds as tax and immigration policy come together.
Stocks are rallying as investors view future policies to be more favorable for themselves. Under a Republican Administration, and potentially Congress, regulation costs will decline. As a former real estate developer, the President is well aware of the benefit of lower interest rates. Policies that favor the dollar, which is also rallying today, could lead to higher earnings for multi-national companies. As the 2017 tax cuts are taken up, it is believed that they will be more favorable for corporations and lower tax rates result in better earnings margins. Generally, when Republicans take control, they are viewed as having more favorable policies and we’re seeing a risk-on environment today. Here is a look at the performance of U.S. equity market segments this morning:
Source: Koyfin
Economy
There is also an expectation that the economy, which is already performing better than people expected this year, may continue to see a lift with some fiscal stimulus, lower tax rates and improved competition environment.
We have seen a 2-year period of rolling recessions by economic sector. First in hospitality and health care, then manufacturing.
We have been on a lookout for recession since the beginning of the year. It is possible that the combination of excess post-pandemic fiscal stimulus and the natural recovery from global logistics problem will keep it at bay. For now, the risk-on trade will dominate markets until we get into the realities of post-election policy making!
We are still positioned correctly though will have to re-evaluate our base case for soft-landing and whether we need to take a more aggressive stance. We are not likely to do this quickly as we are waiting for additional Fed information on interest rates and economic data points.
We have been slightly overweight in small and mid-cap stocks and the markets are favoring those, therefore, our overweight to large cap quality stocks shouldn’t be too much of a performance drag.
On the bond front, we have more interest rate risk, which is going to be a bit detrimental today. However, we are also overweight investment grade corporate credit and this market will bring corporate bond yield spreads in, giving us a relative investment performance advantage.
Fed Meets Tomorrow
The Fed will provide us an update on interest rate policy tomorrow. The market expects a cut of .25% and while the Fed must digest the election news like the rest of us, the cut is still likely in place. Why the cut if the economy is improving? Real interest rates (i.e. the posted Treasury rate) minus the level of inflation have moved above 2%. This level of real interest rates would remain well above their long-term average and still be a bit restrictive.
We would not expect to hear too much from them tomorrow relative to policy changes based on the election, as they will have to digest those when they come next year. Should the economy play out to be better in nominal terms resulting from easier tax policy we would expect to see a slower pace of rate cuts.
You cannot have low interest rates and an economy that is producing real growth of 3.5% or more.
Also, they will have to consider the potential increase in the Federal deficit, which is already high (last fiscal year over $1.8 trillion). To the extent policies move it even higher, we will see a bigger premium in rates and a slower hand by the Fed.
As a swing state voter, I will be glad to have some time back from the plethora of ads I have seen online and on television. Please reach out to your Merit Financial Advisors should you have any questions.
Contact Merit Financial Advisors today for a complimentary consultation.