Weekly Update - On Tenterhooks

At the time of writing, the actual outcome remains deeply uncertain. In five states,the race could go either way. And the President has already called for a recount in Wisconsin where Biden leads by only 49.4% to 48.8% with over 98% of votes counted. And further challenges are likely, for example in Pennsylvania and Georgia where the current gaps between the two are only 5,597 votes and 1,097 respectively. The uncertainty could last weeks – the deadline for conclusion of any legal challenges and selection of electors by each State is December 8 and the formal vote by the electoral college will be held on December 14.

In the weeks running up to the election, the perceived probability of a blue wave saw investors focus on the impact of Biden’s massive $2 trillion 4-year investment plan. This was expected to boost long-term growth but also to spark higher inflation, encouraging “reflation trades” on higher bond yields (see chart) and a swing to more cyclical sectors. Between early August and election day, the S&P Industrials index gained 11.9% versus 2.5% for Technology. Curiously, US stocks rallied by 3.0% on Monday and Tuesday on blue wave hopes and then by a further 4.2% on Wednesday and Thursday as those hopes were disappointed!

If we are correct in judging that Joe Biden will indeed be inaugurated as President with the Senate remaining under Republican control, the new administration could find itself stymied. As we wrote in the Market Update, this scenario “would make policy implementation difficult, keeping Trump’s tax cuts in place. Such a period of stalemate would not be bad for markets, but it could hamper plans of near-term fiscal stimulus”. This would mean no long-term improvement in US growth potential, although we still expect the worsening pandemic to trigger bipartisan support for a new stimulus package in coming months.

The President does have more room for manoeuvre in areas like foreign policy, suggesting a less confrontational stance with allies like the EU and Japan in order to build a coalition to keep pressure on China. Joe Biden has also promised to rejoin the Paris climate agreement on becoming President, which could provide an incentive to boost US research & development of green technologies. Biden would also be likely to adopt a more constructive approach to engagement with multilateral institutions like the United Nations, the World Trade Organisation and so on.

On Thursday, we had the latest central bank policy meetings in Washington and London. The Federal Reserve (Fed) left policy unchanged as expected – key rates remain at 0-0.25% and the Fed will continue bond purchases at around $120bn per month. Chair Jerome Powell also reiterated his call for more fiscal support for the economy. The surprise came from the Bank of England – rates were left at 0.1% but asset purchases were boosted by £150bn rather than the expected £50-100bn. This reflects the central bank’s worries about the COVID-19 induced drop in consumer spending and expectations that hold-ups for exports at the border will slow recovery after Brexit becomes effective next year.

Bottom line. Looking ahead, we expect that overindebtedness and high unemployment will keep inflation low and key US rates close to zero with Fed purchases capping upside pressure on Treasury yields. As post-election uncertainty fades, we expect safehaven flows into dollars to ebb, with the euro resuming its recovery in 2021. Regarding equity markets, policy gridlock has often proved quite supportive given that it provides great visibility to investors and businesses alike. Moreover, fiscal and monetary policy are set to remain supportive for years to come.

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