With the tenth anniversary of the Lehman bankruptcy just passed, one theme of this writer’s message to investors of late has been that politics has now become the main driver of world financial markets replacing the central banks who have played that role for most of the past 10 years. But the problem for investors is that politics is less predictable than the actions of central banks.
Voting on the Donald
It is clear that the view on the outcome of the November mid-term US Congressional elections now diverges significantly from what had been the base case here. That base case has been that the midterm vote would be a vote on Donald Trump and that the Republicans would win because of the all too evident improvement in the American economy and the stock market as a result of the dramatic impact of the Trump administration’s corporate tax cuts in terms of the surge in corporate earnings and the related surge in share buybacks.
The broadest macro measure of US after-tax corporate profits, reported in late August by the Bureau of Economic Analysis, rose by 16.1%YoY in 2Q18, the highest year-on-year growth rate since 1Q12. While taxes paid by the corporate sector declined by 33.4%YoY in 2Q18, following a 39.1%YoY decline in 1Q18 (see following chart).
S&P500 actual reported share buybacks also surged by 42%YoY to a record US$189 billion in 1Q18 (see following chart). There were another US$410 billion worth of buyback announcements in 2Q18, according to Bloomberg.
US after-tax corporate profits and corporate taxes
S&P500 actual reported share buybacks
Still, it now seems that base case could be wrong. A chart of Donald Trump’s popularity rating shows that, after many months of resilience, it broke below the 200-day moving average since early September though it has bounced back in recent days.
The average Trump approval rating declined from 43.7% in late August to a low of 40.6% in mid-September and has since risen to 42.2% on Friday, compared with a 200-day moving average of 42.0% (see following chart).
Meanwhile, perhaps more importantly, the Iowa Electronic Markets, where traders bet real money on the outcome, now shows a 64% probability that the Democrats will regain control of the House of Representatives. Still, there is only a 14% possibility that the Democrats will also win the Senate (see following chart).
President Donald Trump’s average approval rate
Iowa Electronic Markets (IEM): 2018 US Congressional Control Market
The Effect on the Markets of the Democrats Winning Congress
What would a complete Democratic Party takeover of the Congress mean for markets? The view here is that anybody who thinks such an electoral outcome is possible should short the American stock market ahead of the vote.
The reason the US stock market has been rallying, and the economy accelerating, is because of the frontend-loaded impact of tax reform combined with the undoubtedly pro-growth implications of Trump-style deregulation.
Democrat control of both houses of Congress would threaten a complete reversal of these policies as well as a realistic threat of an attempt to impeach the incumbent president. Still, a Democratic takeover of just the House of Representatives, which is now the base case, would also probably be somewhat stock market negative since it would likely mean renewed policy gridlock in Washington, in terms of the ability to get anything done. Impeachment proceedings would also probably be launched even if they would very likely not turn out to be successful.
What Impact Would a Democratic Congress Have on the Trade Issue?
What about the trade issue? In theory, a gridlocked Washington does not hamper the Donald’s ability to implement tariffs as president. So, in that sense, Trump can continue to implement his protectionist agenda. But there is another possibility investors should now consider. If Donald Trump is confident the Republicans can regain control of Congress, there is seemingly no reason for him to do a deal on trade with China ahead of the pending polls.
Still, if he becomes concerned in coming weeks that such an outcome looks increasingly unlikely, then the temptation will grow for the incumbent president to do a deal with China so that he can present a “win”. This is why it was interesting that it was reported in mid-September that Treasury Secretary Steven Mnuchin had invited Chinese officials headed by Vice Premier Liu He for another round of bilateral trade talks in the coming weeks (see The Wall Street Journal article “US seeks new trade talks with China to avoid tariffs”, September 13, 2018). But yesterday it was reported that Beijing has now cancelled the trade talks which were scheduled for the coming days (see The Wall Street Journal article “China pulls out of trade talks with US”, September 22, 2018).
Meanwhile, none of this has stopped Trump from following through on his further 10% tariff on US$200 billion worth of Chinese exports, which will take effect on Monday. Still, it is interesting that some high profile consumer electronic items, such as smartphones, were excluded from the tariffs, suggesting that the Trump administration is concerned about the negative reaction of the American electorate to higher consumer prices.
The conclusion must be that a Trump U-turn on trade becomes more likely the closer to the November elections. This is a point worth making since the reality, at least until today, is that market action, particularly in Chinese stocks, suggests investors have given up on a trade deal. The other point is that Trump’s psychological make-up suggests he will want to do a deal and declare a “win”.