- As recent history has taught us, it’s difficult to handicap elections. At a minimum, investors should be prepared for volatility as November approaches and perhaps beyond.
- Conventional wisdom suggests that a Democratic win could bring a risk-off tone for markets; however, the potential for a significant sell-off based on the tax outlook alone seems unlikely.
- Treasury yield movements during prior regime changes offer clues, but not certainty, on the direction of rates.
This month’s main article examines how the upcoming presidential election may impact the financial markets.
2020 Election: Expect the Unexpected
Eric Souza, Senior Portfolio Manager
In our ongoing client discussions, it’s no surprise that one of the most popular topics has been the upcoming presidential election and its potential impact on markets. I don’t need to state the obvious — that it’s unlikely to be a normal election season — after all, 2020 has hardly been a normal year. Among other factors, the pandemic is likely to significantly increase mail-in ballots, so this may end up being an election month rather than an election night. Moreover, if it’s close, we might see the losing candidate contest the results. So while nobody can accurately predict what will happen in November with any certainty, our quick take is to expect the unexpected.
There are a variety of possible outcomes: Democrats win the White House but Congress remains divided; Republicans retain the White House and Congress remains split; or either Republicans or Democrats sweep the White House and Congress. At the end of September, Biden continued to lead in the national polls by eight points, which was similar to August but down from a high of 11 points in July. Given these polls, much of the analysis and discussion is focused on what a Biden win and a Democratic Congressional sweep would mean for the markets. This could imply some material change, since a divided Congress typically means gridlock and less substantive action (just look at the latest fiscal policy arguing witnessed in August and September).
Before analyzing what might happen, let’s review Treasury yield movements during the last major regime changes. (The last Democratic sweeps occurred in 1976, 1992 and 2008.) The data shows that when the party in power shifts from Republican to Democratic, yields are lower one year later. When there is a shift from Democratic to Republican, yields have moved higher, with the exception of 2000 when yields rallied due to the 2001 recession.
Conventional wisdom suggests that a Democratic win will usher in a risk-off tone (in the near term) due to the potential for higher taxes on corporations and individuals. Such a risk-off tone was evident following two of the three Democratic victories mentioned above, as the 10-Year Treasury yield fell, while in 2016 yields rose after President Trump’s victory. Many believe that one of the key risks of a Biden win may be the potential unwinding of the Trump corporate tax cuts from 2017. This form of stimulus has been constructive for both the equity and corporate bond markets to date. However, Biden has conveyed a preference for zero tax increases for Americans earning under $400,000 per year and has advocated raising the corporate tax rate only modestly from 21 to 28 percent. Thus, the potential for a significant sell-off based on the tax outlook seems muted.
For interest rates, we anticipate less impact over the long term, as seen from previous elections. In part, this reflects the fact that the Federal Reserve is currently projecting to keep the federal funds rate on hold through 2023. Plus, there is still much uncertainty surrounding the economy and a potential vaccine for the Fed to aggressively advocate for higher rates. Front-end yields should continue to remain low, while longer yields will take their cues from growth and inflation prospects and progress on a vaccine. For spread product, we also anticipate less impact, given the credit quality of our approved issuers, which has been relatively resilient, so far, through the pandemic.
We do anticipate some uptick in market volatility leading up to the outcome and, perhaps, immediately following the final election decision. We anticipate two likely scenarios:
1) A Biden sweep will probably lead to an initial rise in Treasury yields, since the market will factor in additional fiscal stimulus and — as a result — increased Treasury supply.
2) If there is a delay in the election results (which is expected), we anticipate a flight-to-quality move with Treasury yields rallying.
One thing is for certain: The 2020 election will be anything but normal. However, we believe our portfolios are well positioned and diversified to handle any potential near-term volatility. So get out and vote and expect the unexpected this election season.
Jose Sevilla, Senior Portfolio Manager
To no one’s surprise, the Federal Open Market Committee (FOMC) kept the federal funds target rate unchanged at a range of 0.00 to 0.25 percent at its September meeting. We might as well all get used to it. Lower for longer may well turn out to be the new normal.
At the meeting, Chairman Powell underscored the uncertainty of the economic outlook and suggested that a successful recovery will depend on how the US can keep the impact of COVID-19 in check. The Fed also explained how it has changed its framework by which monetary policy is used to impact inflation. Going forward, they will now target a 2.0 percent inflation average, using core personal consumption expenditures (PCE), as opposed to a single point in time. This new outcome-based approach will monitor inflation over an unspecified period and will be less impacted by the expectations of inflation approaching or exceeding the target. In other words, the Fed is signaling more comfort with slightly higher rate inflation, and if that’s a by-product of stimulating the economy, so be it. In addition, policymakers will also look to accelerate job market improvement through rising inflation as another necessary factor before shifting policy. All this means that the Fed is likely to keep rates lower for longer, thus allowing for inflation to average above the 2.0 percent target before increasing interest rates.
As for the current data on inflation, consumer prices increased in August, as both headline and core Consumer Price Index (CPI) rose 1.3 and 1.7 percent year-over-year, respectively, while headline PCE and core PCE rose 1.0 and 1.3 percent, respectively. Economists have acknowledged that the uptick in inflation was a function of increased consumer demand and constrained supply of goods due to the shutdowns.
In terms of the employment picture, the US labor markets extended their rebound for a fourth consecutive month. August nonfarm payrolls came in better than expected, increasing by 1.37 million, while the unemployment rate fell to 8.4 percent. The rebound continues for some of the hardest hit sectors (leisure and hospitality, retail, education, and healthcare); however, the August gains were “boosted by the addition of 238,000 temporary Census workers,” according to the report. The US economy has now regained 48 percent of the 22.1 million jobs lost between February and April. However, despite the solid progress, the pace of the overall employment recovery has been slow.
Wages grew by 0.4 percent over the month, bringing the year-over-year average to 4.7 percent. The combination of payroll growth and longer workweeks has resulted in an almost 25 percent jump in hours worked during the third quarter. That’s a nice improvement from the 43 percent decline experienced in the second quarter. This should portend a significant rebound in GDP growth.
According to the revised final estimate, US GDP contracted by 31.4 percent in the second quarter, which is a record plunge and only nominally revised from the earlier estimate one month ago. The latest print showed the decline was almost four times larger than the previous record when GDP plummeted in the first quarter of 1958. The good news, however, is that the recent second quarter drop should mark the end of a severe but short recession, as markets are expecting a similar-sized rebound in the third quarter, as businesses have re-opened and millions of people have gone back to work. Along with the lower-for-longer rate environment, we hope the upward trajectory of the recovery can continue into the fourth quarter and beyond.
Fiona Nguyen, Senior Credit Risk & Research Officer
Poll watching just might be this season’s number one pastime. With less than one month to the US elections, investors are monitoring the financial markets for any signs of distress. Historically, the equity market tends to swing more wildly immediately before and after the election. The recent pickup in volatility, which started in early September, seemed to stem from the risk of a potential increase in the capital gains tax rate. By comparison, the correlation between bond volatility and the elections is less pronounced, with bond spread movement more visible in the high-yield sector as opposed to investment-grade bonds. To be sure, the volatility observed in the equity market hasn’t deterred corporate issuers from borrowing, as bond issuance continues to boom and is expected to reach record levels by year-end.
For corporate issuers, what’s at stake this political season are the implications of possible changes in tax and other regulatory policies. A Biden win might mean higher tax rates on corporate earnings, the possibilities of increased banking regulations, and the potential for antitrust actions against blue-chip tech companies. The financial sector likely faces higher capital requirements and tougher enforcement around compliance issues, a reversion to the policies of the Obama era. While stiffer policies might put pressure on the sector, this scenario certainly benefits bondholders. For the healthcare sector, a Biden victory would have mixed implications. A continuation of the Affordable Care Act would be positive for large healthcare insurers, as it leads to higher enrollment. On the other hand, pharmaceutical companies might fare worse, should they face proposals that could disrupt their existing drug-pricing power. Another sector that likely faces increased regulatory scrutiny is technology, given the recent public focus on data privacy and market competition. Conversely, if the current administration wins re-election, we can expect additional tax cuts, continuing trade protectionism and an overall market-friendly regime. No matter who wins, any near-term policies enacted to support the recovery are likely to provide tangible benefits to the economy, corporate borrowers and investors.
Nevertheless, as we roll into the fourth quarter, most corporate borrowers are still confronted with operating constraints due to plunging demand and social-distancing measures. The expiring impact of this year’s record fiscal stimulus is negative for the economy in the short term and may further constrain demand, as households facing financial hardship pull back on their spending. Against this backdrop, companies will likely go through uneven recovery paths, depending on their exposure to consumer spending and economic shutdowns. Generally speaking, the more essential a company’s products and services are, the more insulated it is and the quicker it will fully regain or even grow its earnings. We have seen this played out with essential retailers, such as Walmart, Target, Lowe’s, and Home Depot, when they reported record free cash flow in the second quarter.
For now, companies continue to issue more debt to shore up liquidity, higher leverage and potential default, which bears watching for lower-rated issuers. However, the Fed’s “lower-for-longer” interest rate policy and accommodative credit backstop still provide outsized support to companies’ liquidity needs. And factoring in demand for yields in this incredibly low-yielding environment, high-quality corporate credits that offer reasonable returns with some level of downside protection are poised to perform well. In constructing our portfolios, we continue to look for issuers with resilient earnings power, solid free cash flow, and strong balance sheets. Ultimately, fundamentals matter most, no matter what the polls say.
Jason Graveley, Senior Manager, Fixed Income Trading
Earlier this year, and particularly after the most tumultuous market period from March to May, money market fund balances were trending higher. That’s no surprise, as investors were coming to grips with the pandemic. Initially, investors were able to enjoy the safety and liquidity of government and Treasury funds, while still benefiting from a comparatively attractive yield of approximately 1.50 percent into February. However, the pandemic and consequent policy responses changed all that, as they ushered in an all-too-familiar market reality. The zero-interest rate policy (frequently referred to as ZIRP) was back. Seemingly overnight, money market fund yields began their downward spiral, thanks to a set of emergency measures that included aggressive federal funds rate cuts.
Currently, fund yields are extremely low, with a number of funds netting 0.01 percent on investments. That’s not a typo. Despite the downward trajectory of rates, investors were comfortable eschewing yield in favor of liquidity and perceived safety. Government and Treasury fund balances exploded through April and peaked in May. However, since then lower volatility and more stable markets (due largely to the many new Federal Reserve credit facilities) have eased investor concerns. This has encouraged investors to put cash to work. Since May, government and Treasury funds have seen month-over-month declines.
When looking at fund flow data, it’s clear there are a number of alternatives that have piqued investors’ interest, particularly at a time when money market funds are yielding one measly basis point. Because of this, separately managed accounts (SMAs) and short-duration bond funds have seen an uptick. Given the overall performance of credit markets, with the Bloomberg Barclays Short Term Index (one-year and under) tracking through January spread levels, this should not be a surprise. A strong second quarter earnings season calmed investor anxieties around corporate profitability and provided clues to how companies would fare, given the increased headwinds.
As a result, investors have regained confidence in corporate cash and are firmly looking to this sector to capture incremental yield and maximize returns. In aggregate, short-term bond funds are at their highs for the year. SMAs, which should also be familiar to many clients, have seen a corresponding increase in usage, as investors look to them as part of a customized solution for their cash needs. Many SMAs are utilizing a combination of repurchase agreements, Treasury and government securities, and credit as a money market fund alternative (or complement). Such an approach may yield anywhere from five to 30 basis points over money market funds. It is this relative value that has driven fund flows in recent months, but we will see how long this trend continues and if other investors will follow suit.
|Treasury Rates:||Total Returns:|
|3-Month||0.10%||ML 3-Month Treasury||0.01%|
|6-Month||0.11%||ML 6-Month Treasury||0.02%|
|1-Year||0.11%||ML 12-Month Treasury||0.02%|
Source: Bloomberg, Silicon Valley Bank as of 9/30/20