Without question, this has been one of the closest and most contentious Presidential elections in our Nation’s history, and with the country already embroiled in a deep Covid-induced recession, we wanted to take a moment to recap what has transpired thus far, where we are now, and our present views on the capital markets moving forward.
With a split government looking increasingly likely, a promising new vaccine on the horizon, fresh stimulus probable, and continued low global interest rates, many of the headwinds and uncertainty the equity markets faced throughout 2020 are beginning to substantially clear.
However, opportunities within the equity markets will vary, as we see the potential for a rotation out of the tech sector that led the way through Covid, and into financials, industrials and energy. For investors with heavy tech exposure, this might be an opportune time to take some risk off the table and further diversify.
Election Results (So Far)
After a dramatic, and at some times confusing several days, the Associated Press named Joe Biden the President-elect and this country’s 46th President. Despite this declaration, the Trump campaign continues to allege voter fraud and is expected to continue to challenge Biden’s win in the coming weeks, much the way we saw during the Bush Gore election.
Turning to Congress, in the House, Republicans thus far have won 201 seats to the Democrats’ 215, with 218 representing a majority and control of the House. In the Senate, Republicans at present have 48 seats, and Democrats have 46 seats, with 2 seats going to independent candidates, and Georgia’s two seats both headed to a run-off election. It takes 51 seats in the Senate to control a majority.
What does all that mean? Assuming for the moment that Biden retains the Presidency, it appears likely that Democrats will control the White House and the House of Representatives, while Republicans retain control of the Senate.
Based on present outcomes, the country is remarkably evenly split. In 2016 Trump won with 306 electoral college votes, narrowly winning PA, MI and WI by approximately 77,000 popular votes to put him over the 270 electoral votes needed to win. This time around, Biden is projected to win the same exact number of electoral college votes (306) by narrowly winning WI, GA and AZ, by less than 50,000 popular votes, to put him over the top.
While 306 electoral college votes seems an impressive total, both of the last two elections were very narrow victories, with neither the Democrats or the Republicans able to legitimately claim any form of broad mandate from the people. So, the country remains solidly politically divided, and we are likely to see legislative gridlock in Washington for the foreseeable future. However, philosophical differences aside, and as negative as legislative gridlock sounds, a divided government has potential positive implications for the capital markets.
Heading into the election, polls suggested a distinct possibility of a “Blue Wave” scenario, whereby voters swept Democrats to significant majorities in the House and Senate, along with a Biden White House. In the absence of control of both the House and the Senate, a Republican Senate will block any tax legislation it finds substantively objectionable.
Thus, concerns have abated surrounding some of the more drastic potential Biden tax policies, such as elimination of long term capital gains, increased income taxes at the highest tax brackets, a rollback of corporate tax cuts that were part of the Tax Cuts and Jobs Act, and a decrease in the most recent increase to the estate tax exemption.
These were all very real possibilities heading into the election, and they could have had a serious effect on both the economy and the capital markets. With a divided government, these measures and their potential impact are largely benign.
With the specter of massive tax increases off the table, the path of economic recovery, along with any ancillary gains or losses in the capital markets, is going to be determined by three primary factors:
- Improvements/declines in Covid-19 and associated vaccines/therapies
- Monetary policy and fiscal stimulus
- Global trade tensions
Amid a substantial worldwide resurgence in reported Covid-19 cases, a fresh round of quarantines in several countries, and several early vaccine disappointments, it now appears that Pfizer may have a vaccine with an initial 90%+ efficacy. This news couldn’t have come at a better time, as the country has experienced over 1 million new cases in just the first ten days of November.
In addition to the Pfizer vaccine, we have also seen an Eli Lily Covid-19 therapy get FDA approval, which will help mitigate symptoms for patients that have already contracted the virus. Indeed, it appears we are on the cusp of a plethora of new vaccines and therapies to help fight the virus, as we enter the dangerous winter months.
The Pfizer vaccine is significant because it is the first to be tested in the United States that has generated late-stage data, and for months researchers have cautioned that the vaccine might only be 60% or 70% effective.
Phase 3 testing is ongoing and per FDA guidance, Pfizer will not file for emergency use distribution authorization until at least half of the patients in their study have been observed for two months after their second dose, to determine if there are any serious side effects. Pfizer expects to cross that threshold in the third week of November.
While at first blush this may seem like the light at the end of the Covid tunnel, there are still several reasons to curb enthusiasm (at least for now). There is no information yet on whether the vaccine prevents severe cases, the type that can cause hospitalization and death. Nor is there any information yet on whether it prevents people from carrying the virus that causes Covid-19, SARS-CoV-2, without symptoms.
Moreover, even if the vaccine proves as effective as it has thus far, initial supplies of the vaccine, if authorized, will be limited. Pfizer says up to 50 million doses could be available globally by the end of the year, with 1.3 billion available in 2021. There are also expected to be distribution challenges. The vaccine must be stored at extremely cold temperatures, making it very difficult or impossible to deliver to many places.
That said, this is close to a best case scenario as could reasonably be hoped for at this stage of the vaccine’s development, and if the numbers, efficacy, and timelines above hold true, the vaccine could have a material impact on the reopening of economies, lowering unemployment, increasing global travel and trade, and aiding in the burgeoning economic recovery.
This, coupled with what will likely be more stringent direction from a Biden administration and herd immunity increased purely by virtue of the number of individuals who have contracted covid and survived, will slowly but surely herald a return to normalcy. That return to normalcy is expected to be accompanied by a substantial increase in GDP, as consumers snap back like a stretched rubber band.
Fiscal & Monetary Policy
Fiscal policy overtures remain accommodating, despite a change in the Presidency. In his first address to the Nation, the President-elect made it clear that the pandemic was his top priority, and there appears to be wide bi-partisan support for a phase four pandemic relief package sometime in early 2021.
However, with a split government, it’s likely to be on the lower end of initial estimates that went as high as $2T. We generally expect markets to take that in stride, so long as the stimulus is actually passed, and that appears probable now that both parties appear ready to participate in negotiations.
We can reasonably expect the Biden administration to pursue its policy goals related to energy, healthcare and climate change. As such, we would not be surprised to see a sizeable infrastructure and/or clean energy spending bill in the early days of the Biden presidency, which would add to whatever Covid stimulus package is tacked onto the CARES Act.
Monetary policy is equally accommodating. The Fed is firmly on record indicating that it will keep rates at their present levels until 2023, signaling continued and predictable central bank support. This policy is echoed by central banks worldwide, as all are combating the effects of the Covid pandemic.
Moreover, the Fed throughout the Covid crises has not only dusted off the 08/09 Great Financial Crisis playbook, but it has drawn up several new plays. We expect the Fed to continue to pull levers like quantitative easing, asset repurchases and pushing out its Main Street Lending program, while expanding its balance sheet where it feels it is necessary to do so to keep capital markets functioning normally. The Fed still has plenty of firepower to pull us through any Covid related softening in the economy that is experienced throughout the winter.
The twin bazookas of an all in Fed, coupled with a healthy infusion of capital in the form of various stimulus and spending bills, should act as substantial wind in the sails of both the US economy and corporate balance sheets, which we are already seeing begin to take effect. Corporate earnings and labor market recovery continue to come in ahead of expectations. Meanwhile, the USD continues to normalize, acting as an earnings tailwind for US multinationals, and S&P 500 cash balance is almost back to record highs, increasing the potential for share buyback and M&A activity throughout 2021. Indeed, retail sales are now at levels above the pre-pandemic peak.
While substantive tax legislation is unlikely given a divided Congress, global trade, and the ongoing trade war against China, is one aspect of the economy where the President can exert substantial influence.
Just as the Trump administration initiated the trade war with China, so too can it be deescalated by the Biden administration. It is reasonable to expect that international trade policy will revert back to something very similar to what it looked like under the Obama administration, which was far less confrontational and more accommodating.
Although it was universally agreed that China exhibited rapacious trade behavior and had little to no regard for international intellectual property, the trade war with China created a cloud over the world economy, and ultimately slowed global GDP. No one could have predicted that would come right as a global pandemic struck and truly impaired global GDP, however, the net effect was a brutal one two punch.
As the pandemic eventually draws to an end, Biden will turn down the heat on the trade war with China. The primary deescalation will take place with our allies and trading partners other than China, of whom we will turn to for assistance to keep the pressure on China, but in a less confrontational style. The need to confront China in several areas is clear and present, but the approach is likely to change, settling on a path somewhere between Obama and Trump. This should benefit both the global economy and multinationals that rely upon China for manufacturing, transportation, and precious metals.
Historical Market Performance
Since election night, equity markets have predominantly ripped higher, and that has the potential to continue throughout 2021, not just because of the election results, but also because the economy will be coming out of a recession and will be entering the beginnings of expansion.
Consider the last economic cycle from mid-2009 through the start of 2020:
- GDP grew an average of approximately 2% per year
- Core inflation averaged only 1.6%, only rarely breaching the Fed’s 2% target
- The 10-year U.S. Treasury yield averaged 2.4%
- The S&P 500 soared off of recession lows, generating a cumulative total return of appx. 500%.
Even as a broader economic recovery takes hold and the recession abates, the election results, specifically a Democratic President coupled with a split Congress, has historically resulted in the highest annualized S&P 500 returns vs any other combination of government. The difference is more substantial than one might expect. Check out the chart below:
However, as noted at the outset, while equity markets appear poised to push higher given the new regime change and the emergence of the country from recession, sectors will matter. This week alone we saw the market whipsaw with the Dow closing flat and the S&P and Nasdaq each losing 1.5% – 2%. Meanwhile, recovery trades tied to airlines, banks, and oil production soared an average of 14%.
We believe that the likelihood of a more certain recovery through progress on a vaccine is likely to lead to a cyclical rotation in the equity market, away from what has worked during the pandemic and more toward value issues like Financials, Industrials and other laggards.
Since what worked in the pandemic was heavily concentrated in the tech sector, the rotation could negatively impact returns vs. more value based stocks. The market leans toward solid growth companies during a “growth is dear” environment, such as a pandemic. Now that a recovery appears to be on more solid footing, we can expect more cyclical stocks to stabilize.
Despite the currently challenging number of new Covid-19 cases, the news on the vaccine/therapy front appears to be bright. This, coupled with easy monetary conditions and likely increased fiscal programs should lead to more stable economic growth going forward and a supported equity market. We do still expect that the benefits of a diversified portfolio will be on full display.
Three Bell Capital