The result of the US mid-term elections is that as expected, the Democrats have gained a majority in the US House of Representatives, while to balance this the Republicans have increased their majority in the Senate. Hence, the US legislative branch is in gridlock for the next two years. We try to steer clear of any political bias, but from our perspective as investors and market observers this was our favoured result and is probably positive for risk assets both in the US and globally.
Historically, this scenario of legislative gridlock has been good for US equity markets for the simple reason that changes in regulation generally prove costly and in a more certain regulatory environment firms can focus on their core business. One of the biggest positives for the US business sector over the last two years has been a dramatic reduction in the flow of new rules that can by association affect business planning.
Had the Democrats gained control of both houses, it is likely that a flood of new rulemaking would have occurred, such as a move for the federal minimum wage to be upped from US$7.25/hour to US$15/hour. That would have been the biggest-ever change and the highest ever relative to average hourly earnings. On the other side of the coin, if the Republicans had maintained control they might have tried to make more tax cuts for individuals to provide a further fiscal boost to underpin Trump’s drive for re-election. But this further stimulus may have fuelled inflation leading to further pressure to raise interest rates—a big worry for equity investors.
This year’s tax changes were positive for productivity, (albeit with a lag of about two years) and also positive for after-tax US profits in the near term. By contrast, fresh tax cuts for consumers could have proven more inflationary than productivity-boosting in their outcome. The effect could have been a faster tightening of monetary policy and a higher rise in bond yields.
Post the results and the removal of that uncertainty, equity markets reacted positively. The November Federal Reserve (“Fed”) meeting has also passed without a change in policy. However, fears over politics and interest rates are not over as the Fed is expected to raise US interest rates on 19th December and then a further three times next year. Our view is that the markets are prepared for these moves.
At the time of writing nearly 90% of companies in the S&P 500 Index have reported their latest quarterly figures, showing earnings growing 27% off the back of tax cuts and sales up over 8% over the year. These figures, combined with the strong US economy, allows the US equity market to continue to be attractive to investors.
Of particular interest to us (as mentioned in recent investment commentaries) are the implications the election result may also have for the path of the Fed’s reduction of its aggregate balance sheet and in particular its level of bond holdings. Earlier this year, it seemed that the FOMC had come under pressure from the Treasury to accelerate the pace of reduction of its balance sheet to minimise rising interest costs as short-term interest rates increased and the Fed was obliged to pay significant amounts of interest to those banks holding excess reserves at the central bank. As many of these banks are non-US owned, the concept of the Fed sending money to foreign organisations runs contrary to President Trump’s ‘America First’ ideology. In fact, we understand that this topic had become a flashpoint between the Administration and the central bank, with the Fed fearing that it could lead the President to seek to change the Federal Reserve Act if it did not follow the Administration’s wishes on this matter.
Now that the Democrats control the House of Representatives, we feel that the political pressure to shrink the Fed’s balance sheet has reduced and we are more confident of the direction of markets over the coming months. The US investment environment remains positive for growth and equity markets. While the exceptional growth of economic output and corporate profits seen this year will likely soon moderate, financial conditions remain favourable. There are risks to the status quo—chief among them being rising trade barriers, higher labour costs and rising interest rates. The trade war is little affected by this election and remains a concern, but the result probably reduces the risk that labour costs and bond yields rise too rapidly. Both are likely to keep trending upward, but if they do so gradually then this growth period and equity bull market probably have a while longer to run.
That said, as a result of the new Fed Chairman’s approach and the turbulent political backdrop, overall monetary conditions are going to remain somewhat more unpredictable than they were under Powell’s immediate predecessors. This may be enough to keep markets ‘on edge’ a while longer.