Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Watching the Horizon Through Rough Waters
Once in a while, we will take our morning coffee and turn on the financial market news to hear what the market pundits and other random talking heads have to say. While all opinions are not created equal, and there is certainly enough banal commentary to go around, there are certainly commentators we respect, whose thoughtful analysis we find valuable. We believe it is dangerous to live in an analytical vacuum.
As you might imagine, all financial market punditry has now turned toward the United States elections and what sorts of market outcomes we might expect from various election scenarios. Effectively, there are four electoral outcomes that we can think about, with perhaps many permutations as to what the longer-range outcomes could be under each scenario: A Biden victory and a Democratic Senate majority “Blue Wave,” A Biden victory and a Republican Senate majority, A Trump victory and a Democratic Senate majority, and finally a Trump victory and a Republican Senate majority “Red Wave.”
Our observation is that a so-called “Blue Wave” is the conventional wisdom, and is the base-case scenario. In fact, we do not believe we have even heard the words “Red Wave” mentioned. We can only presume that is because it is not thought to be a very likely scenario. Therefore, the markets are likely already positioned for at least the immediate impact of a Blue Wave, or are in the process of doing so in front of November 3. Still, the polls seem to be rapidly narrowing in key battleground states to ranges where the incumbent may pull off a victory. So, what is the base-case scenario of a Blue Wave?
In terms of Blue Wave policy, it seems clear that, in the short run, a robust fiscal stimulus package is likely to pass in short order. However, in the longer run we can expect higher marginal personal income tax rates, higher corporate taxes, and higher capital gains rates. Since a Blue Wave decreases the odds of a contested election, as the outcome would appear decisive, we may even have a winner on election night. Biden has been clear in his tax proposals. If unobstructed in Congress, these are likely to pass. This would in all likelihood mean a repeal of the Tax Cuts and Jobs Act (TCJA) of 2017. It would also likely mean an increase in the corporate tax rate from 21 to 28 percent, as has been proposed.
Importantly, Biden has also been quoted as saying that he would once again lock down the United States if “warranted” by COVID-19. We believe the market has discounted at least some probability of this occurring, if not a high degree of such an outcome. We also believe that, if not discounted, it is likely there is some uncertainty as to what is political rhetoric and drumbeating, and what will actually end up as policy. Additionally, the latest Bank of America fund manager survey indicates that the majority of Wall Street professionals believe the election will be contested. Again, it is highly likely that this bit of conventional wisdom has already been at least partially discounted.
The late great Jude Wanniski used to say that everything happens on the margin. It is certainly true in this case. The most interesting scenarios on the margin are those that the markets are not prepared for – the real surprises. Most obviously, the biggest surprise would be the event of a “Red Wave,” where Trump remains in the White House and the Senate is held by the Republicans. We postulate that this scenario might cause the greatest degree of short-term volatility, given that the markets are not at all positioned for this occurrence. Ultimately, however, once the short-term knee jerk reaction is out of the way, the markets will likely view this as a policy “status quo” on a go-forward basis.
In the case of a “split decision” where one party controls the Senate and the other the White House, political gridlock is a likely scenario. There will likely be a great deal of acrimonious rhetoric, but nothing actually achieved – much like the current environment. Traditionally, the market mantra is that gridlock is good for stocks. History provides mixed evidence that this is true, but in recent decades it has rung true. As a general rule, we are inclined to believe that the harder it is for policymakers to pass bad ideas, the better the outcome will be for the economy. The free market allocates resources more efficiently than policymaking professional bureaucrats. Therefore, this is likely to be a good outcome for stocks as a whole, at least in the long term.
However, we are acutely aware that correlation does not mean causation, and just because history suggests that gridlock means a rising market, we await policy proposals before we become entrenched in this view. We do recognize that bipartisanship continues to be a decreasing likelihood in any scenario. Therefore, in the short-run, those trading on the possibility of continued fiscal stimulus are likely to be disappointed, just as they are today.
In any of these scenarios, one thing seems clear. The policymaker reaction to the COVID-19 crisis has forced historic levels of fiscal and monetary stimulus, and it is politically unpalatable to take the punchbowl away no matter who is in charge. While a reopening of the economy is likely to happen more fully in a Trump administration, the economic damage of this reaction to COVID has indeed already been wrought. Many industries will feel the pain of this crisis for years, if not a decade or more to come. We therefore fully expect that monetary policy will be loose, and that fiscal policy will remain accommodative for the foreseeable future.
The increase in debt load will require debt monetization (buying debt that was issued by the Treasury, and by which liquidity is injected into the financial system in order to finance budget deficits). As a general rule, this is a tremendous tailwind for hard assets – recognizing that debt monetization is likely to be a global phenomenon and not merely a domestic one. It is entirely possible that we have ushered in a new era of a so-called commodity supercycle, particularly when these macro tailwinds are coupled with under-investment in finding and producing more of the stuff.
Because it is conventional wisdom, in the event that a Blue Wave is indeed a reality, it is highly likely that the markets will quickly turn to “what’s next” and discount those events in short order. Benjamin Graham once said that in the short run the markets are a voting machine, but in the long run they are a weighing machine. What this means is that in the short-run emotion can dominate market direction as it registers many opinions about the shape of the world tomorrow. We are quite sure that there will be those who are very good at short-term speculation and will trade these outcomes well. However, in the long run, a weighing machine is more reflective of the true sustainable value creation capability of any given company.
This, ultimately, is what investing truly is, and it is helpful to think about the noise around events as exactly that – noise. Or, in the words of Shakespeare, “…sound and fury, signifying nothing.” Real investing requires a long-term view. If anything, short-term dislocations provide opportunities. This is why we must always keep our minds focused and our pencils sharp.
With that, we are off to cast our early vote.
Chief Executive Officer