U.S. Wednesday morning update

Our election note from last night has aged well, so I will just mention a few quick thoughts here.

First, it is still true that President Donald Trump outperformed the polls. The race is still close—and I’ll touch on that more in a moment—but Trump’s outperformance in states like Iowa seems to have been enough to help the Republicans maintain control of the Senate. Several individual races remain too close to call, but right now it looks like the Democrats may only pick up one net new Senate seat, leaving them with a 48-52 minority.

As I wrote about last night, a divided government would imply less fiscal stimulus in 2021. Interest rates are lower on the news, with the 10-year U.S. Treasury yield sitting around 75 basis points as of 6 a.m. Pacific time. A Republican-controlled Senate would also likely prevent Democratic nominee Joe Biden—should he win the White House—from implementing his proposed corporate tax hikes, which would be a positive for the U.S. equity market. Again, these are still forecasts at this stage, but the probabilities have moved in the direction of a split legislature.

Second—and I will say it again—the race for the presidency remains very close. Six states have not yet formally announced which candidate won: Nevada, Wisconsin, Michigan, Pennsylvania, North Carolina and Georgia. But based on the votes that were tabulated overnight, it looks like Biden is now favored to win. For example, PredictIt—a popular betting site—is giving Joe Biden an 80% probability of winning the White House. What happened?

As we cautioned about last night, the mail-in votes that were slow to be counted in the Midwest have continued to come in strongly for the Democratic nominee. Biden now has small leads in the vote counts for Nevada, Wisconsin and Michigan. If Biden were to hold these states, he would hit the necessary threshold of 270 electoral college votes. While the power of the presidency is quite limited under a divided government, we would expect Biden to take a more predictable and multilateral approach to trade relations with China. Such a policy would likely be favorable for investment opportunities in the Asia-Pacific region.

Some patience will still be needed here until an election outcome crystallizes. Wisconsin, Michigan and Georgia have indicated that they could make significant progress in their tabulations today.

Chief Investment Strategist Erik Ristuben and I will be checking in a few more times during the week to keep you apprised of future developments. But ultimately, to be a bit of a broken record here, in the early innings of a new cyclical expansion, we would encourage all of our clients to stay invested through this political season and stick to their strategic plans.

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Editor’s note: Original post from Tuesday, Nov. 3, follows below

Tonight has been a tense night in America. Let’s try to park those emotions at the top of this page, as we believe investing is best done dispassionately. In this post, we’ll try to take an objective look at:

• What we know about the election results so far
• How the U.S. election fits into the bigger picture of our global market outlook
• How the early results and potential outcomes might inform our thinking going forward

What we know from election night

At 8 p.m. Pacific time, none of the key outcomes have been officially called by the major news agencies. But the probabilities have clearly shifted. This is a very, very close race, and that is saying something. Democratic presidential nominee Joe Biden had a large polling lead coming into election night, which suggested at least the possibility of a blowout victory. The so-called blue wave has not materialized. President Donald Trump appears to have an advantage in Florida, Georgia and North Carolina. If he carries these states, the outcome will hinge (like 2016) on the Rust Belt—i.e., Michigan, Wisconsin and Pennsylvania.

Some early data seems to support the notion that Trump could carry these key states as well. However, caution is warranted for the time being. Mail-in voting, which tends to favor the Democrats, is being tallied more slowly in these states and could close the gap. Unfortunately, we are unlikely to know the victor tonight. The secretary of states in both Pennsylvania and Michigan have indicated that their races may not be known until Friday, Nov. 6.

A close presidential race also lowers the probability of Democrats taking control of the Senate. But there, too, we simply don’t have enough races called at this stage to say anything decisively. Democrats would need to win three Senate seats for the slimmest margin of legislative control in 2021. Of the seven most competitive races (all held by the Republican party), none have been called at this time.

Bottom line: The probabilities have shifted toward a gridlocked Congress and a tight presidential decision, but all outcomes remain uncertain.

The big picture

It can be tempting to jump into the weeds about what a certain election outcome might mean for the economic outlook, interest rates or equity markets. And we’ve certainly war-gamed those scenarios internally as an investment firm. But I think tonight—even more than ever—we need to first ground ourselves with a broader view of the investment landscape.

First and foremost is where we are in the global business cycle. The enormity of the shock from the COVID-19 pandemic drove the sharpest economic recession in modern history. But because of an equally historic fiscal and monetary policy response to this crisis, households and businesses have largely been cushioned from the blow.

In the United States, for example, transfers from the government were so large that aggregate household income actually grew during the recession. Global economic activity quickly transitioned back to positive growth in May as economies began reopening. And through October, these positive growth rates have largely continued across the developed and emerging world. It’s not unusual to see above-trend economic and earnings growth as countries emerge from an economic recession. Spare capacity provides room to grow without inflationary consequences or central bank rate hikes. In some ways, our outlook is that simple: We’re early in a new cyclical expansion, and that is a time in the cycle that has typically favored being invested in riskier areas of the market, like stocks and credit.

The virus remains a source of uncertainty, of course, with major European economies transitioning back to partial lockdowns this month. But there are some glimmers of hope, too. Pfizer and Moderna have guided investors to expect efficacy results from their final stage vaccine trials sometime in November. Scientists are cautiously optimistic that a vaccine could be delivered at scale in mid-2021. If that view is correct, life should be looking more normal 12 months from now than it does today—again, supporting a positive cyclical outlook over the medium-term. Vaccines should also broaden the recovery, eventually lifting dislocated sectors (e.g., restaurants and other service sectors).

Key political issues for financial markets

While we think the macro perspective of an early cycle recovery is the critical insight here, politics can shape our outlook around the margins. Here we need to disentangle the White House and Congress.

The president controls U.S. trade policy and can also guide the regulatory agenda. In this regard, a Biden victory is thought to support non-U.S. equity markets (particularly in Asia), as he is expected to take a more predictable and multilateral approach to Sino-American policy. In terms of regulation, Biden has emphasized the importance of the environment, which could be a moderate headwind to the domestic energy sector. Meanwhile, both candidates have talked about stronger antitrust enforcement of mega cap technology companies. Democrats seem a bit more enthusiastic about this issue, however, and so a Biden win would likely be viewed as a negative for technology stocks and the growth style.

The control of Congress, meanwhile, is arguably more important than the presidency for the macro-market outlook. That’s because Congress controls the power of the purse—both taxes and spending. With gridlock around a new fiscal stimulus package in the U.S., a unified Congress (where the Democrats win the Senate) should deliver the most fiscal stimulus in 2021. Enhanced unemployment benefits, household checks and additional funds for small businesses and dislocated industries would likely total $2 to $3 trillion. That would provide even more support for an economic recovery that has surprised most economists to the upside thus far.

In this scenario, long-term U.S. Treasury yields would be expected to rise, and small cap and value stocks—which are more cyclically exposed—should outperform. There could be offsets from tax policy, however, with Biden’s proposal to unwind half of Trump’s corporate tax cut, likely subtracting 5 or 6 percentage points from U.S. earnings growth. Put differently, the implications for interest rates and relative equity styles in this scenario are more apparent than the tug of war for broad equity benchmarks.

Finally, a divided government—where Republicans retain control of the Senate and shift back toward fiscal conservatism—would likely stifle both tax and fiscal stimulus efforts. Again, this would be a mixed bag for equity benchmarks, but would likely lead to lower interest rates and act as a moderate headwind to the opportunity we see in the value style today.

Market reaction

Markets have traded in-line with these scenarios overnight. 10-year Treasury yields have dipped moderately to 82 basis points. NASDAQ futures are trading roughly 3% higher overnight, leading U.S. shares. As a longer-duration style, these securities seem to be benefitting from lower discount rates and perhaps a less bad scenario from tax and regulatory policy.

In the Asia Pacific region, equity markets moved in line with the US, albeit at a much lower magnitude. Australian equities closed the day virtually unchanged (after being down as much as 1.2% through the day), New Zealand equities were up 0.6% and Japanese equities were up over 2% as of writing. The Australian and New Zealand dollar are trading slightly softer on the day, while the Japanese yen weakened against the US Dollar. The Chinese yuan traded  in line with general risk appetite, and is only slightly weaker as of writing.

Key takeaways

It looks like we will all need a healthy dose of patience this week, as results continue to roll in. A protracted period with no known result could inject volatility into financial markets. What we do know is that the U.S. and global economy are both still in the early innings of a new cyclical expansion. Our strongest advice tonight is for our clients to stay invested and maintain their discipline. Politics offer plenty of surprises, but there are some very powerful economic forces already at work that don’t care at all about who is in the White House.