Nordea Am/DoubleLine Capital: Midterms & the Markets: What’s at stake?

5 november 2018

By DoubleLine Capital, manager of Nordea Asset Management’s US Total Return Bond strategy and US Bond Opportunities strategy

We need to examine the possible outcomes for the Senate and the House of Representatives separately. The Democrats are facing an unusually challenging map in the Senate this election cycle, with eight incumbent Democratic Senators facing re-election in states President Trump won in the 2016 election. Summertime Democratic hopes (or conversely Republican fears) of a flip in Senate leadership appear to have been premature. At this point the most likely scenario would see the Republicans retaining control of the Senate, and perhaps increasing their thin (1 seat) majority. These comments must, however, come with the caveat that polling has become less reliable in recent years. Control of the House of Representatives is much more likely to switch to the Democrats. Therefore, the most likely outcome is divided government with each party controlling one legislative chamber by narrow margins. This suggests little legislation of note will pass – the current environment is hardly conducive to bipartisan cooperation. This year’s ballots will barely be counted before both parties begin posturing for the 2020 Presidential election.

The upcoming mid-term election may not matter to the markets as much as many commentators suggest. More important to the markets over the next year is the course of fiscal and monetary policy, corporate earnings and trade policy. Fiscal policy, the purview of Congress and the Executive Branch, has been unusually expansionary for this point of an economic cycle. Federal deficits are expanding significantly at the phase of the business cycle historically associated with falling deficits. This expansionary policy is unlikely to change, regardless of whether the Democrats take the House (or even the Senate). Moreover, policy inevitably becomes even more expansionary when the U.S. economy tips into recession (which we are not now predicting, but which will happen as some point). For the foreseeable future we anticipate a significant increase in the supply of interest rate sensitive assets, primarily Treasury bonds, due to both the deficit and the shrinkage of the Federal Reserve’s balance sheet. Our portfolios are positioned for this prospect, irrespective of the election outcome.

The Federal Reserve seems locked in a path of rate increases until the macroeconomic data shows weakness, by which time the damage may already be done. The pace at which the Fed shrinks its balance sheet has now hit its peak of up to USD50 billion per month and is independent of the outcome of the November election. Regulatory reform, which may be serving as a supply-side boost to the economy, has been driven primarily from within the Trump Administration and is unlikely to change direction until there is a new President.

We believe the Trump Administration’s trade initiatives (or to be less polite, “trade war”) are very significant to the global economy. 2018 has seen a significant divergence between the U.S. equity markets and non-U.S. equity markets, with non-U.S. stocks declining since the onset of trade hostilities in early-2018. Some of the most export-driven markets have seen their major equity indices enter bear market territory (e.g. the Shanghai Composite and the Korean KOSPI). To date, the Administration has used its existing legal authority to pursue its aggressive trade moves. Eventually new trade treaties such as the USMCA (the replacement for NAFTA) will require Senate approval. But with a Presidential election two years away, we see the Trump Administration pressing their efforts to reset the terms of trade with little immediate need for legislative support from the Congress.

This election cycle has seen many Democratic candidates advocate healthcare, immigration and wealth redistribution policies further to the left than in the past. Democratic success on November 6th may encourage Presidential hopefuls to campaign in the primaries on such liberal policies. On the other hand, the failure of the Democrats to pick up a decisive number of seats (and the opposition party typically gains seats in midterm elections) may send the opposite signal to political aspirants.

In short, we do not have an official forecast on the election – we look (with a skeptical eye) at the same polls and analyses as everyone else. Our portfolios are positioned with a recognition that several policy issues are very relevant to the capital markets, namely fiscal deficits, Federal Reserve policy, and trade. However, we see the course of these policy areas as already set in place regardless of the outcome of the midterm election.