Wall St finds a silver lining from a messy election

Markets are fickle, with investors are always looking for silver linings, no matter how contradictory their fluctuations might appear. Investors are inherently optimistic as last week’s fluctuations in the lead-up to the US election demonstrated.

Financial markets – sharemarkets, bond markets and currency markets – were volatile ahead of polling day.

In the lead up to the election the expectation of a “Blue Wave” that would power the Democrats into the White House and to control both houses of Congress were capitalised into markets that were factoring in a massive new coronavirus relief package and even more massive long-term spending on clean energy and infrastructure programs.

Joe Biden's victory has set up the market for a rally.
Joe Biden’s victory has set up the market for a rally.Credit:AP

The stock market, despite the Democrat’s plan to unwind Donald Trump’s tax cuts, was trading higher; bonds had been sold off on expectations of a surge in economic growth and a debt and deficit-driven “reflation” trade; the US dollar had surged and volatility was ebbing.


Fear of the trade conflicts that have roiled the markets during the Trump presidency were receding and there was an expectation, even as coronavirus infections have exploded in the US, that Joe Biden would take the challenge of responding to the pandemic far more seriously and aggressively than Trump.

As the election results started to flow on Tuesday and it became apparent quite early that the Blue Wave wasn’t developing and the Republican hold on the Senate looked likely to be maintained, Treasury yields tumbled and stock prices and the value of the dollar slipped.

As the voting continued and it became obvious the mail-in voting was producing a surge in favour of Biden in the key states, the stock market rose solidly – big tech stocks fared particularly well – volatility continued to decline and bond prices rose and their yields (which have an inverse relationship to the prices) fell.

By Friday, as investors became increasingly confident of the outcome – a Biden presidency, a Republican-held Senate and a reduced Democrat majority in the House – the stock market plateaued, Treasury yields edged back up as bond investors discounted the potential for major debt issuance and factored in the prospect of more monetary policy action and the dollar kept sliding.

Overall, markets that had only days before been enthusiastic about the prospect of the Blue Wave and a turbocharged economic recovery suddenly converted to cheerleaders for the policy stalemate and the constrained government the election seems to have delivered.

Barring an unlikely outcome from the two run-offs for Senate seats in Georgia – which could deliver the Democrats control of both houses if they won both seats – there will be gridlock in Congress. The investors who were, days earlier, banking on something very different have now concluded that is a positive outcome.

Had Trump been able to hold on, of course, they would have found a way to rationalise that as positive, too.

In the face of the coronavirus, the economic damage it has done and the threatening new surge in infections and potential deaths, the continued optimism of investors who have remained upbeat since the markets recovered in March might have been expected to be threatened by an outcome where their government’s ability to do anything substantial is constrained.

Where the Democrats were pushing for more than $US2 trillion ($2.75 trillion) of pandemic relief spending and had plans for a multitrillion-dollar infrastructure and clean energy investments, the likelihood is that the Republicans won’t support anything much more than $US1 trillion of fiscal responses to the pandemic and they certainly won’t support the clean energy spending or the Democrats’ platform on taxes.

The bond market reaction is easier to understand than the equity market’s. Bond investors don’t want massive increases in spending and debt and deficits and a rekindling of inflation. Gridlock protects the value of their existing investments.

The response of currency markets – and technology stocks – can also be explained in similar terms.

The election outcome implies ultra-low, or perhaps even negative nominal interest rates, will remain in place for the foreseeable future.

In the absence of the massive fiscal stimulus from the Democrats, markets had initially envisaged and priced in the burden of responding to the pandemic and the economic damage a third wave of infections will generate remains – as it has been throughout this year – disproportionately with the US Federal Reserve Board.

After last week’s Fed Open Market Committee meeting the Fed’s chairman, Jerome Powell, warned the economy needed more fiscal and monetary support. The US economy had been bouncing back quite strongly before the latest coronavirus outbreaks but remains well below its pre-pandemic levels.

Fed chairman Jerome Powell, warned the economy needed more fiscal and monetary support.
Fed chairman Jerome Powell, warned the economy needed more fiscal and monetary support.Credit:Bloomberg

The election outcome implies ultra-low, or perhaps even negative nominal interest rates, will remain in place for the foreseeable future.

Without large-scale fiscal support the Fed might have to expand its quantitative easing (QE) program (its purchases of bonds and mortgages) and be forced into the yield curve control the markets have called for – an expansion of the QE program into purchases of longer-dated bonds to take control of their prices and yield away from market forces.

That would also lead to a weaker dollar – and, conversely, a stronger Australian dollar despite the Reserve Bank’s attempts to avoid that outcome – and would be good for the stock market, particularly technology stocks, because lower-for-longer interest rates maximise the value of future cash flows in calculations of their present value.

It is the Fed’s response to the pandemic in March, where it took unprecedented monetary policy actions, that has underpinned the US and other sharemarkets despite the wrenching losses of economic output.

The markets are factoring in a lot more of the same, for much longer, now that they expect that with a dividend Congress there will be no radical departures from the status quo.

All that could, of course, change. The stock markets’ bias towards optimism is fragile and remains intact until, usually abruptly, it is shattered by some left-field development (like the emergence of the pandemic) and investors panic and flee to the sidelines in what is generally seen, with hindsight, as an over-reaction.

Stocks are fully valued, particularly technology stocks, and therefore vulnerable to events. Some new twist in the election outcome, a Congressional assault on the big tech companies (Democrats and Republicans, for very different reasons, are joined in their distrust of their dominance) or a new spike in tensions with China are potential catalysts for an abrupt shift in sentiment.

In the meantime, however, despite an outcome that is very different to the one they had priced in, financial markets have looked for and found the positives in what might otherwise be regarded, particularly in the context of the pandemic, as a messy outcome made messier by the novel and destabilising refusal of the incumbent president to accept, yet, the electorate’s verdict.

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Source: Thanks smh.com