Legislative Gridlock, Corrections, and Buying When There’s Blood in the Streets

Last week, the Democratic Party regained control of the House in the midterm elections.  An as-expected outcome to US midterms has allowed stocks and other risky markets (excluding oil) to continue retracing their October losses, since underlying US earnings remain impressive (+28% Y/Y EPS growth and +8% surprise vs. consensus).  A split Congress is likely to result in a return of legislative gridlock, reducing the possibility of further fiscal stimulus and increasing the possibility that US growth will decelerate over time.

Looking back at the past three decades, it is clear that a divided Congress rarely delivers substantive legislative change.  Exceptions were Reagan’s tax reform in the mid-1980s and Clinton’s tax/deregulatory reforms in the late 1990s.  While there is agreement between the two political parties on the need for infrastructure spending, the parties remain divided on the amount and how it should be financed.  Democrats generally think it should be large (~$1 trillion) and federally-financed, while Republicans think it should be smaller (~$200 billion) and co-financed with states and/or the private sector.  Absent an increase in urgency stemming from a growth downturn, it’s difficult to see the two sides reaching agreement.

On the other hand, a possible truce in the US-China trade war is the more interesting potential deal.  This is because the responsibility for trade policy largely remains in President Trump’s hands and because the opportunity comes in just a couple weeks when Trump and Xi meet at the G20.  It’s highly unlikely that there will be an agreement to rollback tariffs; however, there could still be a constructive outcome, such as a US agreement to restart negotiations that have been absent for months, and to not impose further tariffs.  This clarity could drive a substantial rally in trade-sensitive assets (i.e. domestic and emerging market equity indices, along with specific sectors such as autos and semiconductors).  That said, it’s tough to expect any short-term deal on goods trade to reduce long-term tensions between the two countries in the areas of national security, intellectual property rights, and forced technology transfer.

October’s 9.8% peak-to-trough drop was just shy of being the second correction this year.  10%+ corrections have occurred 1x per year on average since 1928, but the last time we saw more than one correction in a single year was in 2008, in which we saw three.  Today’s concerns include slowing growth, rising interest rates (i.e. rising cost of capital), data rolling over (i.e. housing, lackluster consumer spending, etc.), worsening trade tensions with China, weak global fundamentals (i.e. Europe, Turkey, China, Brazil, Argentina, etc.), and an increasingly hawkish Fed.  However, I think draining liquidity (the Fed’s QT program and now the ECB and BOJ tapering their QE purchases) was the primary catalyst for the October correction.  The good news is that global asset prices now reflect this risk.  The bad news is that the growth in global central bank balance sheets is set to decelerate and go negative by January.  I think markets will remain choppy for the foreseeable future and will be very tough to trade. However, the S&P 500 trades at 15.2x 2019 earnings (6.7% earnings yield), which seems pretty attractive relative to the 3.2% yield on 10-Year US Treasuries.  If I had to pick one of these places to put my money for the next 10 years, I would without a doubt pick the S&P 500.

“The time to buy is when there’s blood in the streets,” as the famous Rothschild saying goes.  Most investors are bearish on emerging market equities, even though EM valuations are now significantly lower than at the worst point in the 2015-2016 episode.  Consensus is bullish USD even though US growth could start to converge with the rest of the world.  Most people think the Fed will keep hiking “until something breaks,” and many more think the trade backdrop can only get worse.  I don’t have a crystal ball, but I think sentiment on all of these topics can improve in the coming months.  Historically, stocks have rallied after midterm elections, and retracing recent declines seems like the most likely scenario to me.  But, even if they don’t, at least you’re buying them cheap and when expectations are low.

Top 10 Reads of the Week

  1. Barron’s: Howard Marks on Surviving Market Storms 
  2. Bloomberg: Three Reasons to Fear Another ‘Great War’ Today
  3. The Economist: Gene Drives Promise Great Gains and Great Dangers
  4. Wired: 12 Things You Learn Over Two Decades of Lunches With Stan Lee
  5. WSJ:  Ten Takeaways from the 2018 Midterm Elections
  6. WSJ: US Oil Enters Bear Market on Rising inventories, Worries of Oversupply
  7. Bloomberg: China Has More Distressed Corporate Debt Than All Other EMs
  8. Politico: 2020 Presidential Candidates Who Could Take on Trump
  9. The Economist: Germany’s Chancellor Announces her Resignation as Party Leader
  10. The New York Post: The World’s Stinkiest Fruit Causes Flight Delay

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