What Are the Markets Telling Us?

Posted on Nov 4, 2020 in Economics

What Are the Markets Telling Us?

Anyone who stayed up past about 11:00 last night watching the election returns knows that the polls pretty much got it wrong . . . again. The much-vaunted “blue wave” did not happen. It appears fairly safe at this point to predict that the Republicans will maintain control of the Senate while Democrats will hold onto power in the House. We still don’t know who will be the next president, and we may not know for several days or even weeks. But the markets are telling us that the outcome of the presidential race may be less important than what’s happened with Congress. Many investors had feared that a clean Democratic sweep might lead to big tax increases for businesses and individuals as well as the re-imposition of rigid regulations on the business sector. That outcome now appears less likely than continued Congressional gridlock, and corporate America and investors appear to be breathing a sigh of relief.

But there are other considerations (besides the potential for higher taxes and more regulation) that complicate the stock market’s positive interpretation of yesterday’s voting. In the runup to the election, it appeared as though investors had made peace with the possibility of a Biden presidency and even a blue wave. Biden, along with a supportive Congress, would be more likely to get another large round of stimulus passed, to include big (and badly needed) investments in infrastructure and greater resources to fight the effects of the pandemic. But now, even if Biden winds up winning the White House, it will be hard to get the kind of multi-trillion dollar bill passed that Nancy Pelosi had been seeking in the weeks prior to the election. The lack of a stimulus deal will obviously be a negative for the economy and corporate earnings over the near term. But as of now investors don’t appear overly concerned about that side of the story.

A closer look at today’s stock market performance by industry provides additional evidence that investors expect continued Congressional gridlock, no matter who ends up winning the presidency. The best performing sector today is Health Care, which is up more than 5% as I write. Health Care stocks had underperformed in the weeks leading up to the election because investors had feared that a blue wave might lead to more price regulation for the companies that provide health care services, health insurance, drugs and medical devices. It appears as though the market’s interpretation is that any such legislation in the future is now unlikely to be on a scale that would dramatically impact sales and profits for the Health Care sector.

We are also seeing a big boost in the Technology sector today, with particular strength in the so-called FAANG stocks. The interpretation of the FAANG-stock rally is fairly straightforward as well: A divided Congress is less likely to pass the kind of major fiscal stimulus package that might have been possible had the Democrats run the table. In the absence of an additional round of large-scale fiscal stimulus, the economy may suffer and the Fed will feel greater urgency to add more support on the monetary side. And while the Fed has already made clear that short-term interest rates will remain very close to zero indefinitely, the central bank can and probably will do more to suppress longer-term interest rates. If this thesis is correct, we would expect that longer-term interest rates would be falling today. Indeed, the yield on the 10-year Treasury has dropped from a recent high of about 0.90% to about 0.78%. Low interest rates have been the lifeblood of the FAANG-stock rally because they reduce the cost of owning growth stocks like the FAANGs.

At the same time, the disproportionate spike in the FAANG stocks today could also be signaling that cyclical stocks will face continued headwinds in the absence of additional fiscal stimulus and therefore earnings growth will come at a premium. This notion is further supported by the today’s relative weakness in the cyclical sectors like Energy, Industrials, Materials, and Financials (especially the banks, which are also being negatively impacted by the drop in interest rates).

Investors usually welcome the continuation of the status quo much more warmly than rising uncertainty. From that perspective, it makes sense that a continuation of Congressional gridlock is causing a spike in stocks today (even in the face of continued uncertainty regarding the presidency). However, that maintenance of Congressional gridlock is not a panacea for stocks. We are still in the middle of a nasty pandemic, and corporate earnings are likely to suffer from increased shutdown activity, regardless of whether those shutdowns are mandated by government or self-imposed. The negative pandemic developments raise the stakes for another round of economic support. If none is forthcoming after a reasonable amount of time, we suspect that stock prices will swoon again. But for now, “risk-on” is the all the rage.

Above all else, I am happy to report that the Republic has survived the night. The peaceful transition of power is one of the hallmarks of American democracy, and for now there is no reason to panic over what could happen down the road when all the votes have been counted. But from an investor standpoint, incrementally less uncertainty is a positive, and we are seeing the effects of that today. There’s no telling what tomorrow brings, but today we should be thankful that election day went off without much of a hitch. Here’s to that continuing in the days and weeks ahead.