By: Guy Adami, Director, Advisor Advocacy
Published November 28, 2018
It’s just a few short weeks after the midterm elections. What do the outcomes mean for the economy? Democrats were able to flip 29 seats in the house, and Republicans expanded their control of the Senate resulting in a split Congress. Joined today by Mona Mahajan of Allianz Global Investors, Guy Adami explores some of the implications of the shift as a result of what happened on November 6.
Three Broad Implications of this Shift to a Gridlocked Scenario:
- President Trump’s core economic agenda, which has been centered on tax reform, will likely not be altered materially. Is there a possibility of a second tax reform bill or any other pro-growth stimulus? Not likely.
- Governing by executive order will probably continue. One of the biggest things President Trump has done is utilized executive order action with his trade agenda. While we may get pushback from Democrats vocally, they can’t do anything officially to alter his approach on this. No major changes here.
- Keep in mind, as 2020 draws a bit closer, the work of Congress starts shifting towards presidential elections, and that puts a lot of the legislative initiatives closer to the back burner. As a result, we may not see much progress from either party’s agenda. Neither will want to give the other a win in light of the 2020 agenda. Prior to the election, we tend to see volatility. After midterm elections, there is more stabilization historically. We had a small rally, but have gotten more volatility with on-going rotation in the marketplace. Perhaps people are refocusing on some of the broader economic issues.
What Should the Market Focus On?
The three main issues – the Fed, China tariffs, and slowing global economies – are core “walls of worry” the market will have to overcome. Out of these three, the Fed is the most pressing thing on the agenda. In the most recent meeting, they indicated we are expecting one more rate height this year, perhaps even an additional one in 2020. What do rising rates mean for the market? If you think about the stock market, it’s basically cash flows discounted at a risk-free rate. As that rate starts to rise, market valuations become somewhat capped. With the Feds in play, you have a creep into the real economy, meaning mortgage rates go up, auto lending rates and student rates go up. As the Fed continues down this path, we have historically seen that 10 out of the last 13 tightening cycles have ended in a recessionary environment. This is where we are most cautious.
Is the Fed Moving Too Quickly?
Guy posed this question to Mona, asking if the data suggests that it might be time to slow down a bit. She responded that from a historical perspective, they haven’t moved fast at all. Looking ten years prior to the crisis, the average funds’ rate was 3.5%, and we are now sitting at about 2.25%. Not only are we nowhere near an average; we are also at a point where the economy no longer needs an immense amount of stimulus. The balance sheet has been quite bloated for some time and for nearly three years now they’ve been hiking rates (the speed has been pretty gradual), but as we are nearing the end point, this is where you have to be careful.
We haven’t seen inflation yet creep up in the numbers, so there isn’t any inflationary spike to run away with. Do they really need to take the Fed rates to 3 or even above? That becomes the question of what is the natural rate for the Fed Fund, what’s been normal. That will have to become more data dependent. These last few rate hikes will make the difference in either a mistake or a soft landing.
Where Should the Fed’s Focus Be?
When asked if the Fed should be focused on the stock market, Mona mentioned that the Fed’s core mandate is unemployment and inflation, and that’s where they should stay. Our new Fed Chair has come from a financial market background. He understands financial markets pretty well, and he has to be watching what is happening with the volatility in October and the midterm elections. He also understands global markets well, and what he is seeing must play into his thinking. What we have heard from him is that he is data dependent and focused on the core dual mandate.
Guy also asked about an imminent deal with the Chinese. Mona’s response? “I don’t see an imminent deal happening. I think President Trump wants real, material change out of China not only from a trade perspective but also with intellectual property, etc.” While a negotiation or final deal may not be imminent, she is of the opinion we will get a resolution on trade. This trade deal is one of the only levers Trump has that could pass with a gridlocked Congress, but it could be another 12-18 months until we have a deal.
Investable Opportunities in a Late Cycle
Where to invest? One thing we have seen is a rotation away from some of the growth areas, mainly technology, discretionary, and energy, toward things like utilities, real estate, and staples. Going forward, we talk about playing offense and defense, and equity markets still can do quite well in this late cycle. Over the next 12 months, you don’t want to miss out on a big swing, but you do want to be a bit more defensive. We still like technology and healthcare, but balance that with things from the staples sector. Equities are still our preferred asset class at this point in the cycle, but slowly bonds and even treasuries at 3%+ start becoming interesting.
Passive Vs. Active Management
With potentially higher volatility in the future, Mona suggested a shift to more active management might be necessary. Passive management has come to the forefront over the last 9-year period, post-financial crisis. We had low volatility, rates that were abnormally low, and had a very nice steady S & P return. It made a lot of sense to just index a lot of your assets, with an average return of 12 or 13% annually. As you look forward to the next 9 or 10 years, we may not have this same environment. We have had two 10% corrections this year, and with the Fed in play and a potential slowdown, we’ll probably get returns that are a bit more modest than what we have seen. People have to start thinking more about active management, particularly in areas where it will be harder and harder to index.