The mid-term elections in the US are widely regarded as a referendum on President Trump’s first two years in office. While markets have largely priced in a benign outcome, we outline below the tail risks and what they mean for the US economy and global financial markets.
The US mid-term elections will be held Tuesday. Generic polling shows Democrats leading 50-43%. The popular 538 Website looks at each congressional race in granular detail. Here, the Democrats are seen as having a 7 in 8 (85.2%) chance of winning control of the House of Representatives. On the other hand, the Republicans are seen as having a 5 in 6 (84.2%) chance of keeping control of the Senate.
Unlikely outcomes in recent political events (Brexit, 2016 US elections) have led some critics to claim that polls are somehow “wrong.” We remind our readers that polls ultimately reflect probabilities. So-called tail risk is present everywhere, and one can never rule out a “tail event.” We note that many of the Congressional races are within the margin of error in the polls, making a tail event more likely.
The current House makeup is 235-193, with 7 vacancies. Of those vacancies, 5 were previously Republican and 2 were previously Democrats. 538 sees an 80% chance that the Democrats win between 21-59 seats, with 39 seen as the average gain. This would allow Democrats to regain control by a 234-201 margin.
The current Senate makeup is 51-47, with 2 independents that caucus with the Democrats. 538 sees an 80% chance that the Democrats win up to 2 seats and the Republicans win up to 4 seats, with 0.7 seen as the average gain for Republicans. This would allow Republicans to widen their margin to an effective 52-48.
We think a split Congress is the base case and favored outcome for markets. The economic status quo would continue (tax cuts and regulatory relaxation are retained) but having one Democratic chamber would allow for some checks and balances on the Executive branch. The Fed will feel comfortable continuing the tightening cycle, while another round of tax cuts becomes more unlikely.
If the Republicans are able to hold on to both houses, we think this would ultimately prove to be negative. The administration may feel emboldened to enact another round of ill-advised tax cuts. The budget deficit has already widened even as the economy continues to grow robustly. Another slug of fiscal stimulus might buy a couple more quarters of growth, but it would come at a high cost when the next recession hits.
If the Democrats are able to take back both houses, we think this too would be eventually be negative for the markets. The Democrats could try to rescind the tax cuts and regulatory rollbacks enacted so far that equity markets have liked. While these efforts are unlikely to be veto-proof, they would nonetheless add to an uncertain policy backdrop. It is also possible (though unlikely) that the Democrats pursue impeachment proceedings against President Trump. Here too, the uncertainty would likely weigh on the markets.
Special Counsel Robert Mueller is widely expected to present his findings after the midterms. The last several weeks have been very quiet on this front, as Mueller has honored Justice Department guidelines to avoid any actions that might influence the outcome of tomorrow’s elections. No one knows what he will present to Deputy Attorney General Rod Rosenstein.
Barring findings that President Trump was directly involved in conspiring with Russia to interfere in the 2016 elections, impeachment proceedings seem highly unlikely. However, a Democratic-controlled House will likely open or reopen investigations into the Trump administration’s dealings with Russia. At the very least, this could add to the sense of gridlock in the final two years of Trump’s term.
Regardless of the makeup of the next Congress, press reports suggest that there will be a massive shakeup in the Trump administration. Based on interviews with “14 senior White House officials, administration aides and Republican operatives,” the Washington Post speculates that Attorney General Jeff Sessions and Homeland Security Secretary Kirstjen Nielsen may be on the way out due to deteriorating relations with Trump. Defense Secretary Jim Mattis and Interior Secretary Ryan Zinke are also thought to be vulnerable.
Looking at the economic team, Commerce Secretary Wilbur Ross may choose to leave the cabinet after the midterms. However, it is widely believed that Treasury Secretary Steve Mnuchin and National Economic Council Director Larry Kudlow will remain in place, as will USTR Robert Lighthizer and Director of National Trade Council Pete Navarro. To us, this suggests that President Trump’s confrontational approach to foreign trade will remain intact and that’s not good for market sentiment.
The US economy continues to enjoy strong momentum. GDP growth is forecast by Fed at 3.1% in 2018, 2.5% in 2019, and 2.0% in 2020. GDP grew 2.2% in 2017. GDP rose 3.0% y/y (3.5% SAAR) in Q3, and early indicators (auto sales, PMIs) suggest that Q4 will also be relatively firm. The Atlanta Fed’s GDPNow model forecasts Q4 growth of 2.9% SAAR, while the New York Fed’s Nowcast forecasts 2.6% SAAR.
Price pressures are rising. CPI rose 2.3% y/y in September, down from the cycle peak of 2.9% in both June and July. However, core PCE deflator is running at the Fed’s 2% target for much of this year and likely to edge higher. Elsewhere, average hourly earnings rose 3.1% y/y in October, a new cycle high and the highest since 2009. As such, we believe price pressures are likely to continue rising and this should keep the Fed on its preferred tightening path.
A 25 bp hike in the Fed Funds target range in December to 2.25-2.50% is widely priced in. Looking ahead to 2019, the Fed Dot Plots show it intends to hike three more times to a 3.00-3.25% range. Fed funds futures are still pricing in only two hikes in 2019 after one in December. We continue to believe that markets are underestimating the Fed’s capacity to tighten next year.
The fiscal outlook is already worsening. For the FY2018 that just ended in September, the deficit was -$779 bln and equal to -3.8% of GDP. Revenues rose only 0.4% despite strong economic growth, while outlays rose 3.2%. Bloomberg consensus sees the deficit widening to -4.7% of GDP next year and -4.8% the year after that whilst assuming growth of 2.5% and 1.9%, respectively. These forecasts generally mirror the IMF forecasts.
Assuming that the next US downturn is a run of the mill recession, one should expect outlays to jump 7% and revenues to slump -4%. If this happens, then back of the envelope calculations suggest that the deficit will blow out to around -6% of GDP (and likely more). Bond markets are especially wary of rising Treasure issuance coming even as the Fed continues to pare its purchases and shrink its balance sheet.
The dollar is outperforming after a subpar 2017. In 2017, USD was down against all the major currencies and all but six of the emerging market currencies. So far in 2018, USD is up against all major and emerging market currencies. With the Fed likely to continue tightening in 2019, we believe interest rate differentials will continue to favor the greenback.
The game-changer for the dollar is the next US recession. When that hits (and our best guess is late 2019 or early 2020), the budget deficit will likely blow out just as the Fed starts cutting rates. The government would likely come under pressure to keep the deficit under control and so the likely combination of tighter fiscal policy and looser monetary policy in the US would be very dollar-negative.
US equities are outperforming after a solid 2017. In 2017, MSCI US rose 20% vs. 20% for MSCI DM. So far this year, MSCI US is up 1.5% YTD and compares to -3.3% YTD for MSCI DM. With growth likely to remain robust, we believe this outperformance will continue. The big unknown is the impact of the ongoing trade tensions on company earnings.
US bonds are underperforming. The yield on 10-year US Treasury bonds is +79 bp YTD. This is behind only the worst DM performer Italy (+131 bp). With inflation likely to rise further and the Fed continuing to hike well into next year, we think US bonds will continue to underperform.
Our own sovereign ratings model shows that the US improved modestly and moved back (barely) into AAA territory. It has been going back and forth between AAA and AA+ for several quarters and bears watching. If the recent tax cuts coupled with a US slowdown lead to significant fiscal deterioration, we think this would likely push the US deeper into AA territory and trigger downgrades for the US. This would be dollar-negative, to state the obvious.