MATASII MID-TERM ELECTION TAKEAWAYS
MACRO: US - PUBLIC POLICY
- Despite record voter turnout and a staggering $5 billion political spend between both parties, Democrats' hoped-for 'blue wave' failed to materialize on Tuesday. Instead, the reality was closer to a purple wash,
- The Democrats' takeover of the House suggests that they will almost certainly use their subpoena power to investigate everything from Trump's tax returns to his financial ties in Eastern Europe to his purported "relationship" with the Kremlin. It also signals that Trump is in for a two-year struggle as partisan gridlock will almost certainly hamstring parts of his agenda,
- Fiscal deadlines become riskier under a divided Congress,
- Substantial risk of shutdown at the next spending deadline in 2019,
- Discretionary caps for defense and non-defense spending,
- No major tax legislation,
- Repealing the Affordable Care Act is dead in the water - ACA now appears stalled in purgatory,
- Initial wrangling & delay of the implementing legislation for the US-Mexico-Canada Agreement (USMCA)
- A lot of centrist Democrats will be headed to Congress. In order to secure that victory and retake control of the House it is important to recognize that it took a lot of wins in center- to center-right congressional districts.
- “When it comes to budgeting, the only way to agree on a budget may be to give candy to everyone, and spend more rather than less”,
- “For these reasons, the Fed will continue to lift the fed funds rate and the U.S. yield curve should maintain an upward bias going forward from here”,
- Big Oil is celebrating big midterm wins as voters rejected measures that would have restricted drilling in Colorado and put a tax on carbon emissions in Washington. Oil companies had spent tens of millions of dollars to oppose the initiatives, with shares of Colorado producers - Noble Energy (NYSE:NBL), Anadarko Petroleum (NYSE:APC) and Devon Energy (NYSE:DVN) - under pressure since the proposal won a spot on the ballot. Colorado is the fifth-largest U.S. oil producing state,
- Expect the Treasury curve to bear steepen by the end of 2018 and into 2019, resulting in more vol on the long end.
With control of Congress split between Democrats (the House) and Republicans (the Senate), we can expect legislative gridlock. The question becomes, does political divisiveness degrade into political Civil War, or will some semblance of bipartisan cooperation be accomplished. If the charts are correct, and wave 3-down is coming after this wave 2-up rally completes, then political Civil War may be on the horizon. It will be interesting to see if a rollback of the corporate tax cuts happens, and if so, will tax cuts be shifted to the middle class and small businesses?
A Divided Congress Means the Following:
THIS INCREDIBLY DANGEROUS SOCIALIST IS NOW CHAIRPERSON OF THE POWERFUL BANKING & FINANCE COMMITTEE: CONGRESS WOMAN Maxine Waters
Representative Maxine Waters, a fierce Trump critic and Wall Street foe, appears poised to take control of the House's powerful financial services committee.
As chair, she will be able to subpoena officials at financial regulatory agencies for testimony and other information.
Gridlock in Washington could stall the White House's bid to deregulate banking and financial services.
The halt of deregulation legislation could also affect other sectors like energy, industrials and small business.
Rep. Adam Schiff (D-CA), who will lead the House Intelligence Committee,
told the Los Angeles Times on Monday that he will revive the investigation into so-called "Russian collusion" - vowing to go after Trump's personal business interests.
A Democratic House and Republican Senate:
- We would not expect a substantial market reaction to this result. From a policy perspective,
- We would expect the following under a divided Congress outcome:
- Taxes: We expect no major tax legislation under a divided Congress scenario. However, with no major policies due to expire in 2019 or 2020, this would have little effect on our baseline fiscal policy view that tax policy goes from growth-positive to growth-neutral by late 2019. It is likely in this scenario that the Democratic House would try to pass tax legislation that redistributes the 2017 tax cut toward lower income households while also reversing the limitation on the state and local tax deduction. However, it would be very unlikely to attain the 60 votes needed in the Senate in this scenario, if it even came up for a vote.
- Spending: Under a divided Congress, we would expect Congress to approve discretionary caps for defense and non-defense spending for FY2020 and FY2021 that are roughly flat in real terms with the spending caps for 2019 that Congress approved earlier this year. This is the assumption underlying our fiscal projections.
- Infrastructure: We expect that a major infrastructure program such as the President has proposed would be unlikely under any election scenario, though some funding could be diverted toward infrastructure out of other non-defense spending, as it was this year. While President Trump and congressional Democrats have both supported infrastructure programs, the details differ substantially and, more importantly, Democrats might not be motivated to reach an agreement with the White House prior to the 2020 presidential election.
- Trade Policy: A Democratic House would be more likely than a Republican House to block the implementing legislation for the US-Mexico-Canada Agreement (USMCA), but we expect that the deal would eventually be approved. However, potential opposition could prompt President Trump to initiate the withdrawal process from the current NAFTA, forcing the House to choose between the new deal or none at all. In the absence of a legislative agenda in this environment, the White House would be more likely to pursue additional tariffs on imports from China, in our view (implementation of further tariffs by early 2019 is our base case).
- Regulatory: Control of the House would have little direct impact on the regulatory agenda, since (1) it would likely be blocked in the Senate and (2) most regulatory changes under the Trump Administration have been carried out with existing authority and have not needed congressional approval. That said, it is likely that regulatory scrutiny of some regulated industries (health care, financial services) could increase through House committees.
- Fiscal deadlines: Fiscal deadlines become riskier under a divided Congress. The next spending deadline is December 7, 2018 (before election results take effect) but this is likely to be pushed to either Q1 2019 or September 30, depending on what Congress decides after the election. Under a divided Congress, there will be a substantial risk of shutdown at the next spending deadline in 2019, though whether it happens will depend on the political environment at that point. The debt limit will be reinstated March 1, 2019 and we expect Congress will need to raise it by August. We note that the two most disruptive debt limit debates in recent memory, in 2011 and 2013, both occurred in a divided Congress.
For once the pollsters were - generally - right, and while there was no blue wave, Democrats did win the House majority as most predicted, as Republicans not only kept the Senate majority but gained a few additional seats. The outcome, which had been extensively analyzed in advance, can be summarized in one word: gridlock.
Here, as explained by Goldman's political economist Alec Phillips, is what the US divided congress, i.e., gridlock, means for the US economy, and for US policies for the next several years.
- A consensus outcome. With many races not yet called, most major media outlets have called the overall midterm election results: the House majority has flipped to the Democrats (many results are still outstanding but most projections suggest a split of roughly 230 Democrats and 195 Republicans in the House) and the Republicans will keep their majority in the Senate (most projections show 53-54 Republicans and 46-47 Democrats, including independents). The overall outcome was the widely held consensus view going into Election Day, though the Republican gain in the Senate is larger than expectations.
- No major changes on taxes: We expect no major tax legislation to become law under a divided Congress. Democratic House leaders might attempt to pass tax legislation that redistributes the 2017 tax cut toward lower income households while also reversing the limitation on the state and local tax deduction. A proposal to partly reverse the corporate tax cuts is also a possibility. However, a proposal making substantial revisions to the 2017 tax reform legislation is very unlikely to attain the 60 votes needed in the Senate, if it even came up for a vote. Our projections of the growth impulse from fiscal policy assume no substantial tax changes will be enacted over the next few years, and the election result should not change this assumption.
- Spending is likely to be extended around current levels: Under a divided Congress, we expect Congress to approve discretionary caps for defense and non-defense spending for FY2020 and FY2021 that are roughly flat in real terms with the spending caps for 2019 that Congress approved earlier this year. While President Trump has called for a 5% cut in discretionary spending—this would work out to around a $65bn (0.3% of GDP) reduction—we expect that Democratic House leaders will insist on a higher level closer to the current level. Note that whatever is decided is unlikely to influence spending trends until 2020, as the spending caps for FY2019 were already agreed to earlier this year. This legislative scenario is consistent with the assumptions underlying our current government spending forecasts.
- An infrastructure deal seems unlikely: A divided Congress is unlikely to enact a major infrastructure program, in our view. While President Trump and congressional Democrats have both supported infrastructure programs, the details differ substantially and, more importantly, Democrats might not be motivated to reach an agreement with the White House prior to the 2020 presidential election.
- Healthcare will be a major issue: Healthcare was listed as a top issue for more voters than any other in exit polling, with 42% listing it as the top issue. The Democratic-majority House is likely to pass drug pricing legislation, but it could be blocked in the Senate. That said, with President Trump also publicly supportive of drug pricing changes, Senate Republicans could come under pressure to reach a compromise on the issue.
- Trade policy should not be directly affected: A Democratic House poses some risk to passage of the implementing legislation for the US-Mexico-Canada Agreement (USMCA), but we expect that the deal would eventually be approved. However, potential opposition could prompt President Trump to initiate the withdrawal process from the current NAFTA, forcing the House to choose between the new deal or none at all. We do not expect the midterm election outcome to change the Administration’s direction on US-China trade policy, where we think additional tariffs in 2019 are more likely than not.
- Little impact on the regulatory agenda: Control of the House has little direct impact on the regulatory agenda, since (1) most House-passed legislation would likely be blocked in the Senate, and (2) most regulatory changes under the Trump Administration have been carried out with existing authority and have not needed congressional approval. That said, it is likely that regulatory scrutiny of some regulated industries (health care, financial services) could increase through House committees.
- Fiscal deadlines become riskier: Fiscal deadlines will become somewhat riskier under a divided Congress, in our view. The next spending deadline is December 7, 2018 (before election results take effect) but this is likely to be pushed to either Q1 2019 or September 30, depending on what Congress decides after the election. Under a divided Congress, there will be a substantial risk of shutdown at the next spending deadline in 2019, though whether it happens will depend on the political environment at that point. The debt limit will be reinstated March 1, 2019 and we expect Congress will need to raise it by August. We note that the two most disruptive debt limit debates in recent memory, in 2011 and 2013, both occurred in a divided Congress.
- No major signal regarding 2020: We do not believe that the midterm election result sends much of a signal regarding the outlook for the 2020 presidential contest. While there are examples of a party winning the White House two years after flipping the House majority (President Obama in 2008 followed a Democratic win in the House in 2006), there are examples of the opposite as well (the 1994 and 2010 Republican midterm wins were followed by Democratic wins in 1996 and 2012). Perhaps more tangible is the potential Republican gain of 2-3 seats in the Senate, which, if the result holds, would make it more difficult for Democrats to win control of the Senate in the 2020 election, all other things equal.
Source: Goldman Sachs
TRUMP'S COMMENTS ON THE RESULTS:
President Trump on Wednesday tweeted a warning to Democrats who have threatened to investigate him upon reclaiming a majority in the House of Representatives:
"If the Democrats think they are going to waste Taxpayer Money investigating us at the House level," Trump said, "then we will likewise be forced to consider investigating them for all of the leaks of Classified Information, and much else, at the Senate level."
One week ago, amid a duel of forecasts between Morgan Stanley "rolling bear markets" thesis, JPMorgan's head quant Marko Kolanovic tripled down on his bullish outlook, when he cautioned that "many investors are positioned for a ‘rolling bear market’ and are exposed to the risk of a ‘rolling short squeeze’ into year-end."
He also predicted that after the US market sell-off and slowdown in China, "progress on the trade war is more, rather than less, likely." And echoing the sentiment presented by Nomura's Charlie McElligott, who earlier today anticipated today's market melt up as levered funds chase indices into year end, Kolanovic said that with global Hedge Funds down ~4.5% and the market up ~2% YTD, missing the past week’s ~5% rally would have made a big difference, especially as their shorts moved more than longs.
In retrospect, and 6% higher from the October 30 lows, Kolanovic was right, and after solid gains over the past several days, the JPM strategist says that "the question is what should investors do next?"
Perhaps not surprisingly, Kolanovic remains bullish and thinks that the market will move higher into the year-end, as "investors may have to participate on the upside (appropriate exposures may be high-beta indices such as Russell 2000 and MSCI Emerging Markets)" especially in the context of McElligott's source of "short gamma" which is pushing the market ever higher the more stocks rise. Furthermore, Kolanovic notes several factors that improved since last week "that keep our upside view intact." He lists the following:
- November is shaping up to be the strongest buyback month on record (based MTD activity observed by the JPM desk).
- Short convexity of market makers is rapidly declining and may turn long. This should be positive as it will bring back intraday reversion as opposed to momentum. This reduces realized volatility, and many investors will misconstrue this as a return of the ‘buy the dip’ environment.
- Realized volatility is expected to decline. Systematic investors (such as vol targeters) will start rebuilding positions into year-end. This may not be a main driver, but could add ~$1bn of inflows per trading day into year-end.
- Implied volatility has declined, with the VIX term structure reverting to contango. For some strategies this is a positive signal.
- Next week, 1M price momentum will turn positive for most equity indices globally (1M ‘anniversary’ of the crash), and may lead to CTA inflows or short covering.
- Elections have passed, and it removed the tail risks of a blue wave (impeachment, repeal of tax reform, etc.). This should be positive for sentiment.
- Split congresses have historically been positive for the market, and this time it reduces the probability of the most negative trade war outcomes.
- The US earnings season turned out to be one of the strongest in a decade: 98th percentile on bottom line, 97th percentile on top line, above average on guidance/revisions
Kolanovic then rounds out his note with some observations on the US midterm elections, stating his "out of consensus" belief that a split Congress "is the best outcome for US and global equity markets." Specifically, policies of the US administration in 2017 were strongly pro-business (we pointed that out in 2016). However, in 2018, policies of the US administration were strongly anti-business.
Kolanovic also counters conventional thinking by saying that if we had a “red wave,” the administration might have seen it as an endorsement of the trade war, and attempt to mitigate the breakdown in global trade with more US fiscal expansion (e.g., 10% middle-income tax break, etc.).
As the President cannot count on Congress or the Fed for more easing, he will need to do what is in his power to keep the economy rolling – drop the damaging trade war and turn it into a winning deal.
Finally, the JPM strategist coments on the October sell-off whichhe dubs as "one of the more curious events in US financial history." This is how he frames last month's freak market rout:
In 2015, we were saying that systematic investing and electronic liquidity provision can yield any price outcome regardless of fundamentals. The worst 1-month sell-off since Lehman this October reminded us of this again.
While the fuel for the sell-off was systematic flows, low liquidity and HF deleveraging, the catalyst was politics. It was essentially a miscalculation and a conflict between the US Administration and Fed going into important midterm elections. Shortly before the sell-off, we wrote about Equity markets being very uneasy with the increasingly hawkish rhetoric from the Fed. At the same time, we pointed out that Trump may be miscalculating on trade and the US market was not pricing the negative EPS impact of a trade war. The reasons for the Fed ramping up hawkish rhetoric going into one of the most important midterm elections in US history will continue to be questioned by market practitioners. There was a global trade war scheduled to start, signs of stress from US housing to emerging markets, an ongoing crisis in the Eurozone (Italy), and finally the worst 1-month sell-off since Lehman (recall that historically rhetoric eased/turned dovish for much smaller reasons such as the last French elections).
Going into the election, the US administration perhaps miscalculated that the NAFTA deal would be enough to prop up market sentiment, and that the Fed would provide dovish ‘cover’ for the trade war. In the context of rallying the Republican base on immigration and trade (rather than winning independents and moderates), trade rhetoric escalated going into election (e.g., the ‘Super Micro’ affair). A dovish Fed would have propped up markets and underwritten the trade war policy going into election, but the hawkish Fed ended up triggering the market crash.
His conclusion is that the "catalysts for the October crash were miscalculations on both sides, and we hope lessons will be learned." Whether he is right will largely depend on Trump's actions going forward: whether he takes a conciliatory stance having lost the House, or if - as some such as Goldman have suggested - Trump will double down on his trade war rhetoric and efforts, and pushes even harder on his core policies which would lead to another round of market instability.
So what happens next? Below is a summary of some of the more notable sell-side views laid out this morning, courtesy of Bloomberg:
- “The midterms are unlikely to have a significant bearing on the economy,” Capital Economics U.S. economist Andrew Hunter wrote in a note. “But they probably raise the risk that political uncertainty once again becomes the dominant theme over the next couple of years.”
- “The results of the election shouldn’t change the immediate path of the economy or monetary policy,” independent strategist Marty Mitchell said in a note, citing the Trump administration’s already implemented fiscal initiatives. “For these reasons, the Fed will continue to lift the fed funds rate and the U.S. yield curve should maintain an upward bias going forward from here.”
- NatWest Markets strategist John Briggs suggests fading the long-end buying in Treasuries, because once the dust settles, market movements will be “more muted” and quickly refocus on the underlying fundamentals and upcoming events. Briggs also said political gridlock may give way to increased spending. “When it comes to budgeting, the only way to agree on a budget may be to give candy to everyone, and spend more rather than less,” he said.
- “Trade uncertainties, investigations and impeachment threats are downside risks,” Dana Peterson, an economist at Citigroup, wrote in a note. “The persistence of U.S. trade disputes with other economies, including China and the EU poses downside risk to global (and ultimately U.S. growth) via trade, confidence and inflation channels.”
- Going forward, the removal of uncertainty and realization of the expected outcome should be supportive for risk assets, the yield curve returning to a more normal flattening pattern, and a modestly weaker broad dollar, Goldman Sachs analysts wrote in a note.
- “With election results in hand and largely in line with expectations, the bond market quickly looks ahead to Thursday’s FOMC announcement,” said Colin Lundgren, global head of fixed income at Columbia Threadneedle Investments. “ No rate hike expected this month, but investors will be looking for language in the statement that highlight the Fed’s concern for changing financial conditions, and potential impact on future policy decisions.”
- Finally, focusing on the yield curve shape, Wells strategists including Mike Schumacher still expect the Treasury curve to bear steepen by the end of 2018 and into 2019, resulting in more vol on the long end, given midterm election impact on the U.S. bond market typically fades within a week and supply remains heavy. Plus, there’s “little link between Congressional control and