US Elections – The Proof Is In The Pudding

The week ahead is a huge for data and events.  First and foremost is the US Presidential election on Tuesday.  Polls show Democratic contender Biden well in the lead over President Trump, with around an 8.8% gap in polling between the two contenders.  However, Biden has lost some ground over recent weeks in polls including in key toss-up races though betting odds actually show a late shift back in favour of Biden.  Polls predict that Democrats will also take the Senate from the Republicans and add to their majority in the House. 

While the polls indicate a Blue Wave for the Democrats there is still a healthy degree of cynicism given how badly they predicted the outcome of the 2016 election, when most pollsters predicted a Hillary Clinton victory.  In recognition pollsters say they have changed their methodologies to correct for past errors.  The proof is in the pudding and until elections are over, investors will be holding their breath.  Even after election day itself, it is not clear that we will see an outcome quickly.  A jump in early voting may complicate things as well as the large amount of mail in voting, which could in some states take days to count. 

The problem may be more acute if the election is a close call, which polls are admittedly not suggesting, but nonetheless, the potential for multiple legal challenges and even civil unrest should not be discounted.  Note that States technically have until December 14 to certify election results.  Some states that will be key to either side will be Florida and Pennsylvania as well as Michigan,  North Carolina, Arizona and Wisconsin.  Florida in particular, could be essential, and could be one of the first states to be called on election night.  The winner in Florida has gone on to the win the Presidency in 13 of the 14 last elections. It is also one of the closest races this time around.

All of this is taking place at a time when Covid-19 cases are accelerating, potential a bad omen for Trump given that polls have shown widespread disapproval over his handling of the virus.  Indeed, Covid inflections in the US increased by 97,000 on Friday, the largest one day increase since the outbreak of the virus. The jump in cases were led by Midwestern states, some of which are major battleground states in the elections.  Admittedly, some of the increase in cases can be ascribed to higher testing rates, but hospitalisations have also risen sharply. 

All of this doesn’t bode well for the economy.  While the third quarter registered an above consensus increase in US GDP of 33.1% on annualised basis, the outlook for Q4 looks much softer and without a new fiscal stimulus package, momentum will slow sharply.  The labour market in particular is weak and while this week’s US October employment report will likely show a strong increase in non-farm payrolls (consensus 610,000), there will still likely be around 10 million fewer jobs since February.  The Federal Reserve FOMC meeting this week is unlikely to deliver any further support, with the onus squarely on more fiscal stimulus.

Equity markets have clearly become increasingly nervous heading into the election, with US stocks registering their worst week since March amid election nervousness and spike in Covid infections.   Tech stocks were hit despite mostly beating earnings expectations.  The US dollar in contrast, made some headway, but didn’t really fully capitalise on the sell off in stocks and rise in risk aversion, that would usually be expected to propel the currency higher.   If polls are correct and there is a strong outcome for Democrats in the election, stocks will likely find their feet again, while the US dollar will resume weakness. 

Markets Facing a Test of Reality vs. Liquidity

Risk assets ended last week under pressure (S&P 500 fell 2.4%) as some US states including Texas and Florida began to reverse opening measures and Anthony Fauci, the infectious diseases expert, warned that some states may have to return to full “shelter in place”.  Banks were among the worst performers even as they came through the Fed’s stress tests in reasonably good shape.  The Fed did however, cap buybacks and dividend payouts for the 33 banks that underwent tests. However, the reality is that banks were hardly likely to increase dividends over the next few months, while the 8th biggest banks had already suspended buybacks.  Perhaps what spooked markets was the news of “additional stress analyses later in the year”.

It feels like equities and risk assets in general are facing a test of reality vs. liquidity. It’s hard to fight the growth in excess liquidity global (G4 central bank balance sheets minus GDP growth) which has risen to its highest rate since Sep 2009, coinciding with a solid run in global equities over that period.  Clearly forward earnings valuations have richened but while absolute valuations appear rich (S&P forward price/earnings ratio has risen to 24.16), relative valuations ie compared to low global rates, are more attractive. This hasn’t stopped the intensification of concerns that after a solid market rally over recent months, the entry of a range of speculative investors is leading to a Minsky Moment.

Investor concerns range from the fact that the rally has been narrowly based, both in terms of the types of investors (retail investors piling in, while institutional have been more restrained) and type of stocks (momentum vs. value), the approach of US Presidential elections in November and in particular whether there could be a reversal of corporate tax cuts, as well as the potential for renewed lockdowns. Add to the mix, geopolitical concerns and a certain degree of market angst is understandable. All of this is having a growing impact on the market’s psyche even as data releases show that recovery is progressing somewhat on track, as reflected for example in the New York Fed’s weekly economic index, which has continued to become less negative and the Citi Economic Surprise Index, which is around its highest on record.

China, which was first in and now looks to be first out is a case in point, with growth data showing ongoing improvement; data today was encouraging, revealing that industrial profits rose 6% y/y in May though profits in the first five months of the year still fell 19.3%, with state-owned enterprises recording the bulk of the decline.  While there are signs that Chinese activity post-Covid is beginning to level off, domestic consumption is gradually improving. This week, market activity is likely to slow ahead of the US July 4th Independence Day holiday but there will be few key data highlights that will garnet attention, including June manufacturing PMIs in China and the US (ISM), and US June non-farm payrolls.

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