Thoughts through the cycle: W2 November ’20

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US elections and the market: Groundhog 1-0 Change

  • The heavy-weight boxing title fight between Gene Tunney and challenger Jack Dempsey on 22nd September 1927 in Chicago became famous as the ‘battle of the long count’. After flooring Tunney in the 7th, Dempsey refused to move to a neutral corner in accordance with the new rules, delaying the referees count and thus allowing Tunney more time to recover and get to his feet. Tunney went on to win on points and retain his title, and despite the controversy, Dempsey’s magnanimity in defeat won him the nation’s respect. The two became good friends.
  • America’s current long count may take weeks to resolve in a legally-conclusive manner, and even then, one might not want to bet on the incumbent conceding graciously or even conceding at all. In the meantime, the market goes on, and the various gyrations deserve a closer examination to see what the future portends even before the outcome of recounts and run-offs is known.
  • As ever, the starting point should be the US bond market. The clearest conclusion from the US election is that the scale of a likely Democrat win had been vastly over-estimated by opinion pollsters, and that the ‘blue wave’ was not going to manifest itself as the Democrats conceded ground in the House of Representatives and the Republicans retained the Senate (subject to run-offs). The graph below shows the 30yr treasury yield in magenta and the ICE bond volatility index (MOVE index) in yellow. The huge fall in 30yr yields (23bps in 24 hours) and the collapse in bond volatility tells not only of reduced hopes of massive fiscal stimulus, but also that positioning had been extraordinarily crowded and one-way into the election itself. The fall in volatility belies how dominant the derivative market has become in 2020 with respect to the effect it has on the direction of underlying markets.

Source: Bloomberg, 9th November 2020.

  • Less stimulus means less reflation, or less potential for inflation if that’s the way you want to look at it. The graph below shows USD 5y5y inflation (5yr inflation in 5yrs time) during election week, and the sharp fall on the 4th November suggests that without the blue wave outcome, the possibility of the US descending into a deflationary episode is still not off the cards.

Source: Bloomberg, 9th November 2020.

  • To add to the fun, Thursday 5th November was a scheduled Fed open-market committee (FOMC) meeting. For obvious reasons, the Fed tries to stay as neutral as possible during elections. Chairman Powell was however notable in his press conference remarks as talking up the possibility of further Fed action just as the possibility of outsized fiscal stimulus seemed to be receding with the way the electoral dice appeared to be falling. This was a notable change from recent Fed communications which had been hinting that monetary policy had been expended and that fiscal stimulus would have to do the heavy lifting going forward.
  • The fall in bond yields in part reflected market anticipation of the Fed having to do more in terms of quantitative easing (QE), and this was reflected too in currency terms, with the DXY (below, green) falling sharply will silver (blue) rose sharply. Silver is normally highly responsive to inflation but post-election it led gold in the rally despite inflation expectations falling per the 5y5y graph above. This suggests the market was starting to price further currency debasement from QE rather than inflation per se.

Source: Bloomberg, 9th November 2020.

  • Because it’s America, the stock market grabbed all the attention as usual. The Nasdaq rose 9.4% on the week per the graph below – quite a move for an overall electoral outcome which looked like one of the worst possible outcomes (no blue wave ‘mandate’, republican senate gridlock, contested presidential election). Some pundits suggested Republican control of the Senate would mean Biden’s tax proposals (including hiking corporation tax from 21% to 28%) would be stillborn and this would be equity positive. Falling yields and ‘low-flation’ is also seen as good for the tech growth factor, and so on.

Source: Bloomberg, 9th November 2020.

  • These are all valid arguments, but the real story is a little more prosaic: markets are so thin and liquidity so poor that any major repositioning by derivatives investors can create outsized movements in the underlying. The blue wave trade favoured value over growth, so tech’s outperformance over value was mainly just a derivative-driven rotation. The ‘travel-and-arrive’ mentality of markets also saw aggressive volatility selling with the VIX volatility index falling 35% from 38% to 25% during the week, further exacerbating the move higher in equities. There wasn’t a huge amount of ‘real’ investing going on, with equity index futures volume radically outweighing single-stock cash trading. For those thinking last week was a foretaste of how equities will trade in Biden’s America, there may yet be some unpleasant surprises, especially with equity valuations so full.
  • While the overweening influence of the derivatives market on the underlying equity indices may mean the signalling effect of equity prices post-election is somewhat limited, nonetheless there was some positive economic data out during the week. The ISM composite services index posted another expansionary month in October (56.3 vs 55.5 for September), while October’s payroll number was sharply ahead of expectations (906k vs 680k est, with jobs appearing in the ‘right’ part of the private sector). October’s unemployment rate was 6.9% vs 7.6% est.
  • In a year of wild economics statistics, it’s necessary to dig a bit deeper than just the headline unemployment rate. The graph below shows US labour participation rates. This is the graph that shows that the recovery is not the one the equity market is ‘pricing’ if indeed that is what equity prices mean these days. This is the graph that shows the extant risk of deflation, notwithstanding Fed attempts to debase the currency through QE. If one graph were needed to show that the problems that surfaced in 2007 never went away, this would be it. We’ve had some sort of recovery since then, but one based on debt and financial engineering rather than ‘real’ growth in terms of productivity or participation. This graph is not the American dream. Fixing this would likely fix much in American politics.

Source: Bloomberg, 9th November 2020.

  • Lower economic participation means lower spending and lower demand for credit. In this situation, banks usually become more reluctant to lend, and this can be seen by the falling loan balances on bank balance sheets. Data from the Fed on commercial and industrial loan trends (below) bears this out. This is exactly the same trend which Christine Lagarde was highlighting a few weeks ago at the ECB’s policy press conference as one which was contributing to ‘negative inflation’ and thus demanded further monetary and fiscal support. Clearly the problem is a shared one, if not one of common cause.

Source: Board of the Governors of the Federal Reserve, 30 September 2020.

  • Taken together, the election result should be considered a disappointment for progressives, and probably disappointing for those who therefore wanted a rebalancing of American society. It is likely that the Biden administration will mark more continuity than markets were anticipating a few weeks, albeit with fewer colourful and entertaining tweets. The equity markets are once again telling a story of reflation and recovery, while the bond markets are telling us that deflation beckons, at the same time as the precious metals warn of currency debasement. Business as usual then.
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